University of Geneva - HEC

Advanced Finance
Fall 2014
Problem Set 1

Instructions:

• Please hand in your written answers at the beginning of lecture on Thursday, October 16th , 2014.
No late submissions will be accepted.

• Please hand in one solution set for each group.

• Please write legibly, in capital letters, the surnames, first names, and group number (in this order)
of each member in the group, at the upper left corner of the first page of your answer sheet.

• Your answers need to be succinct and to the point; you might get penalized for long-winded answers.
Your handwriting also needs to be clearly legible.

• Please justify all your answers, even in multiple-choice questions. I will give no credit for answers
without an explanation.

• The problem set will be graded out of 100. The number of points that each problem is worth is
written in brackets.

1
1 Definitions [10 points]

Which of the following statements is correct?

a. A decision involves risk if it leads to consequences that are not precisely predictable, but follow a
known probability distribution.

b. A decision involves uncertainty if it leads to consequences that are not precisely predictable, and
though they follow a known probability distribution, the true probabilities may be over/under
weighted by the decision maker.

c. An asset A stochastically dominates an asset B if and only if asset A pays at least as much as asset
B in all states of the world.

d. All of the above.

e. None of the above.

2 Comparing Lotteries [10 points]

Consider the following two risky assets:

Asset A Asset B

State Probability Payoff Probability Payoff

1 0.25 1 0.33 3
2 0.50 7 0.33 5
3 0.25 12 0.34 8

Which of the following statements is correct?

a. Asset A state-by-state dominates asset B.

b. Asset A stochastically-dominates asset B.

c. Asset A mean-variance dominates asset B.

d. All of the above.

e. None of the above.

2
3 Preferences [10 points]

Assume that you can choose between 4 assets: A, B, C, and D. You are told that A  D, C  D, and
B 6 C.
Which of the following statements is correct?

a. A  C

b. C  A

c. B  D

d. All of the above.

e. None of the above.

4 Expected Utility Theory [10 points]

Let u be the vNM utility function, and let wealth equal 0. What is the expected utility of asset A that
has possible payoffs x1 and x2 , which occur with probabilities p1 and p2 , respectively?

a. EU T (A) = x1 p1 + x2 p2

b. EU T (A) = u (x1 p1 + x2 p2 )

c. EU T (A) = u (x1 ) p1 + u (x2 ) p2

d. EU T ((A) = u (p1 ) x1 + u (p2 ) x2

5 Risk Aversion and Wealth [10 points]

00
Letting u (x) be the utility function, absolute risk aversion is defined as − uu0 (x)
(x)
and relative risk aversion
00 (1−ρ)
is defined as −x uu0 (x)
(x)
. The utility function u (x) = − x1−ρ , for ρ = 3, exhibits:

a. CARA and IRRA

b. DARA and CRRA

c. DARA and IRRA

3
 d. IARA and DRRA

e. None of the above.

6 Certainty Equivalent [10 points]

Consider an agent with zero initial wealth whose preferences are characterized by Expected Utility Theory
with a logarithmic vNM utility function u (x) = ln (x) for all x > 0. The agent is offered the following
1
lottery: win 27 with probability 3 and win 8 with probability 23 . Find the value C such that the agent is
indifferent between the lottery and receiving C with certainty.

7 Buying Insurance [20 points]

An individual has initial wealth of $400 and has a 20% chance of having a car accident. If an accident
happens, he will incur a cost of $300, leaving him with $100; if an accident does not happen, he loses
nothing. The individual’s preferences are represented by Expected Utility Theory with a vNM utility
√
function u (w) = w.

1. Is the individual risk averse, risk neutral or risk loving?

2. What is the expected amount of money he will lose? What is his expected wealth?

3. What is his expected utility of wealth?

4. What is the certain wealth level that gives him the same expected utility as the risky situation he
faces?

5. What is the maximum premium he would pay to an insurance company to buy full insurance?

6. What is his risk premium, i.e., how much more than his expected loss is he willing to pay for full
insurance?

7. How do your answers to the above questions change if the individual’s utility function is u (w) =
√ √
3 w + 20 instead of u (w) = w. Explain.

4
8 Financial Compliance [20 points]

The Financial Services Authority (FSA) is tasked with ensuring that all listed firms comply with disclosure
and other requirements. Complying with these requirements is sometimes quite costly, so some firms
choose not to do so.
For simplicity, assume that cost of compliance is c, and that if a firm chooses not to comply, there is a
probability p that the FSA detects and levies a fine f on the non-complying firm. In order to decrease the
number of non-complying firms, the FSA is considering doubling the amount of monitoring (in essence,
doubling the probability p of detection) or doubling the fine levied on detected firms.
If an arbitrary firm’s initial wealth is W and its preferences can be represented by Expected Utility
Theory with risk-averse von Neumann-Morgenstern utility function u, which of the two options considered
by the FSA would be more effective?

Reminder : A function u is concave if, for all x1 , x2 and λ ∈ (0, 1), we have: λu (x1 ) + (1 − λ) u (x2 ) ≤
u (λx1 + (1 − λ) x2 ) .