Problem Set 2

Behavioral Finance
Summer 2012
Prof. Dr. Alexander Klos

Problem 1: Expected Utility and Bayes’ Law

Erwin owns a share in X Inc. and has no further wealth. Having a concave utility function, he
behaves expected utility maximizing. The price of his share strongly depends on the upcoming
annual general meeting. If the CEO announces a favorable earnings development, Erwin will be
able to sell his share for 400 € on the following day. If the CEO announces an adverse earnings
development, Erwin`s share will drop to 100 € only (ignoring transaction costs and assuming for
the sake of simplicity that only these two states may occur). The market (and Erwin, too) estimates
a 50% probability for a favorable announcement and a 50% probability for an adverse
announcement. The current stock market quote is 256 €.
a.) Erwin considers selling his share immediately (at the current quote) or waiting one day and
selling after the general meeting. Can you help him with that decision without knowing
precisely his utility function (just concavity)? If YES, how? If NO, why not?
b.) More precisely, assume that Erwin`s utility function on wealth x is √ . Given this
utility function, please confirm your answer to part a.).
c.) While Erwin is still contemplating parts a.) and b.), a stock analyst and buddy of Erwin
informs him that according to an analyst report, X Inc. will announce a favorable earnings
development. However, Erwin`s longstanding experience tells him that his buddy`s
predictions are not always correct: Indeed, given a favorable earnings development his
buddy correctly predicts a favorable earnings announcement. However, given an adverse
earnings announcement the analyst wrongly predicts a favorable earnings announcement,
with a probability of 1/3, too. Does the new information change Erwin`s answers in parts
a.) and b.)?

Problem 2: Expected Utility and Bayes’ Law (Exam Question SS11)

Suppose that there is a stock with a market price of 100€ which can either go up to 110.25€ or go
down to 90.25€ in the next year. The riskless asset in the market generates a return of 2.01%.
Erwin, an EUT decision maker with a wealth level of 100€ and an utility function of √ , is
indifferent between the two investment opportunities.
a.) What is the probability of the stock going up next year?
b.) An analyst who had the same expectations about the stock as Erwin observed a signal that
the stock will go down in the next year. He uses Bayesian updating to get to an updated
(posterior) probability of the stock going up of 45%. How much trust does the analyst have
in the signal he observed, i.e. what are the likelihoods of that signal, if the probability of
observing the signal at all is 50%? (Please use an a priori probability of the stock going up of
67.5% - this is not the correct answer - if you did not answer part 1.)

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Problem 3: (µ, σ)-preferences

a.) Show that a quadratic expected utility function implies (µ, σ)-preferences for a risk-averse
decision maker.
b.) Calculate the certainty equivalent of a lottery l (1000, 1/2; 0, 1/2) for a (µ, σ)-decision
maker with the utility function u(x)= − at the wealth levels 1,000€ and
, , ,
10,000€. (Note: The certainty equivalent CE represents the safe consequence for which the
decision maker is indifferent between CE and the lottery that has to be evaluated.)
c.) Are (µ, σ)-preferences “reasonable” from a descriptive point of view?

Problem 4: (µ, σ)-preferences and Diversification

a.) Stock A has a return standard deviation of 20% and stock B has a return standard deviation
of 10%. Stock A has an expected return of 20% and stock B has an expected return of 10%.
Plot the efficient portfolio frontier under the assumption that the two stocks returns are
uncorrelated with each other. Show points A and B on the plot. (For these plots, it would
probably be easiest to use a spreadsheet to print the plots.)
b.) Show on the plot the minimum variance portfolio. Does it contain positive quantities of
both A and B?
c.) If the interest rate is 0%, roughly draw the tangency line on the plot. Do you think that the
optimal portfolio will contain positive quantities of both stocks? More of A or more of B?
d.) Now redo a.) to c.) under the assumption that stock B has a high correlation, of 0.9, with
stock A. After answering a.), b.), and c.), describe in words the difference that the
correlation of 0.9 makes.
e.) As an investor, which world would you rather live in, the world described by a.) to c.), or
the world described by d.)? (Assume that the assets A and B are the only assets that there
are to invest in.) Explain your answer.

Problem 5: Expected Utility Theory

Harry is expected utility maximizer. About his utility function u is nothing known but the fact that u
is strictly monotonically increasing and that Harry’s certainty equivalent for the lottery L is 70 €.
0.5 100 €
L=
0.5 50 €
Use the information about Harry’s preferences to conclude which of the following lotteries (a or b)
Harry will prefer. If necessary, draw a picture to support your reasoning.

70 € 90 €
0.6 0.2
a= 0.2 50 € b= 0.5 40 €
0.2 10 € 0.3 0€

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Problem 6: Expected Utility Theory
Max has been kidnapped and is forced to play Russian Roulette:
A number of bullets are loaded into a revolver with six chambers. Max then points
the revolver at his head, pulls the trigger, and is killed if and only if the revolver
goes off. Each chamber is equally likely to be in firing position, so if the number of
bullets is b his probability of being killed is b/6.
Max is expected utility maximizer. Suppose further that the maximum amount he is willing to pay
to have one bullet removed from the gun initially containing only one bullet is $x, and the
maximum amount he is willing to pay to have one bullet removed from a gun initially containing 4
bullets is $y, where x and y are both finite. Finally, suppose that he prefers more money to less
and that he prefers life (even after paying $x or $y) to death. Let UD denote his utility when dead,
which is assumed to be independent of how much he paid (as suggested by empirical studies of
the demand for money); and let UA0, UAx, and UAy denote his utilities when alive after paying $0,
$x, or $y, respectively.
1. Given this description of Max’s preferences, what restriction are imposed on UD, UA0, UAx’
and UAy?
2. Assume you are in Max’s situation. Would your choice for x and y be
a. x<y,
b. x>y,
c. x=y?
What is Max’s choice as an expected utility maximize? (Hint: normalize Max’s utility
function.)

Problem 7: Expected Utility Theory

Heinz-Lothar is a risk-averse EUT decision maker. He makes the following preference statement
regarding the following two lotteries.

8000 € 6000 €
0.5 0.5

L1 = p L2 =

0.5 2000 € 0.5 4000 €

a.) His certainty equivalent (CE) for lottery L1 is 4,000 €. What can be concluded for the
certainty equivalent CE2 that Heinz-Lothar assigns to lottery L2? Provide an interval that
contains all possible values of CE2!

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 b.) Heinz-Lothar now compares L1 to a third lottery L3 with

8000 €
0.25
0.50
L3 = 6000 €

0.25 2000 €
Which one will he prefer, L1 or L3?
c.) How does the certainty equivalent of L3 compare to the certainty equivalent of lottery L2?

Problem 8: Plausibility of risk aversion

John‘s utility function over terminal wealth is given by u(x)=log(x). He has the choice between the
following two lotteries. John’s current wealth is 12,000€.
a.) Assume that John decides between the following lotteries:
Lottery A: Win 110€ with probability 0.5
Win -100€ with probability 0.5
Lottery B: Win x€ with probability 0.5
Lose 50€ (i.e. win -50€) with probability 0.5
Determine x numerically in such a way that John is indifferent between these two lotteries.
b.) Assume that John decides between the following lotteries:
Lottery A: Win 1,100€ with probability 0.5
Win -1,000€ with probability 0.5
Lottery B: Win x€ with probability 0.5
Lose 500€ (i.e. win -500€) with probability 0.5
Determine x numerically in such a way that John is indifferent between these two lotteries.
c.) Assume that John decides between the following lotteries:
Lottery A: Win 5,500€ with probability 0.5
Win -5,000€ with probability 0.5
Lottery B: Win x€ with probability 0.5
Lose 2,500€ (i.e. win -2,500€) with probability 0.5
Determine x numerically in such a way that John is indifferent between these two lotteries.
d.) Assume that John decides between the following lotteries:
Lottery A: Win 11,000€ with probability 0.5
Win -10,000€ with probability 0.5
Lottery B: Win x€ with probability 0.5
Lose 5,000€ (i.e. win -5,000€) with probability 0.5
Determine x numerically in such a way that John is indifferent between these two lotteries.
e.) Do you think this pattern of choices between A and B is reasonable?