FINANCIAL THEORY AND CORPORATE POLICY

SUGGESTED ANSWERS: SEMINAR 1

QUESTION 1

1) Marginal utility is the first derivative with respect to W.

Therefore, marginal utility is positive signifying the function is increasing in wealth

Risk aversion is the rate of change in marginal utility.

Therefore, the utility function is concave and is consistent with risk aversion.

2) Absolute risk aversion, as defined by Pratt-Arrow, is

Therefore, the function does not exhibit decreasing absolute risk aversion. Instead it has constant
absolute risk aversion.

3) Relative risk aversion is equal to

Therefore, in this case relative risk aversion is not constant. It increases with wealth.

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QUESTION 2

1)

Therefore, the individual would be indifferent between the gamble and £4,898.98 for sure.

Expected wealth is 5000 as the gamble is actuarially neutral. This amounts to a risk premium of
£101.02 (=5,000-4898.98).

2) Given that the Markowitz risk premium is £101.02 and less than the insurance offer of £125 the
person would choose to go without insurance.

3) The second gamble, given the first loss, is £4,000 plus or minus £1,000. Its expected utility is

Now the individual would be willing to pay up to £127.02 for insurance. Since insurance costs only
£125, he or she will buy it.

QUESTION 3

Graphical analysis using two CDFs shows a crossover between them. Therefore, the first order
stochastic dominance does not exist. Alternatively, the following table can be built:

Payoffs PDFA PDFB CDFA CDFB CDFB-CDFA Sum (CDFB-

CDFA)
200 0.1 0 0.1 0 -0.1 -0.1
300 0 0.3 0.1 0.3 0.2 0.1
400 0.8 0.4 0.9 0.7 -0.2 -0.1
500 0 0.3 0.9 1.0 0.1 0
600 0.1 0 1.0 1.0 0 0

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The second to last column is can be used to check for first order stochastic dominance. Since signs vary
there is no first order stochastic dominance. The last column can be used to check for second order
stochastic dominance. Neither asset is stochastically dominant.