ENFIN-400-02

Midterm #1
Professor: Pedro Campn
01/10/2014

Date:

Assistant: Xu Lidan
minutes

Time: 150

Roberto Sahr

Questions
1. Indicate whether the following statements are TRUE or FALSE,
providing an explanation for your answer:
a. The Expected Utility Hypothesis assumes the existence of
objective probabilities for every possible outcome of a
game.
(0.25 points)
b. The Expected Utility Hypothesis is a theory that affirms that
individuals make decisions by calculating the probabilityweighted average of the happiness or satisfaction provided
by all possible results for every alternative under
consideration (in short, the expectation of the utility of each
alternative investment) and then choosing the one with the
higher expected utility.
(0.25 points)

a. FALSE: the probabilities that appear in the EUH are personal

beliefs, not objective probabilities. For example, in the
Ellsberg paradox, when you were told to choose from 1)
games A and B, and 2) games C and D, in which a ball had to
be drawn from an urn with 30 red balls and other 60 balls
either black or yellow and a prize was awarded according to
whether the result was a red ball or a black ball, in choice 1),
and either a red or possibly a yellow ball, or either a black or
possibly a yellow ball, in choice 2), you had to make a
decision depending on what you believed the probabilities of
red, black and yellow balls to be, namely, you were totally

unaware of the real or objective probabilities and your

choices were simply reflecting your personal beliefs.
Preferences when payoffs of two different games are the
same are revealed in the shape of personal beliefs about the
likelihood of payoffs in each game. The same concept is
employed in the mean-variance analysis, investors choose
among portfolios according to what they believe about
means and variances (and covariances), which entail taking
expectations with some subjective probabilities.
b. FALSE: The EUH claims that the behavior of some individual
can be described by means of the maximization of the
expectation of some utility function, but the EUH does not
affirm that such a maximization is carried out explicitly, only
that this individuals choices, if some axioms are satisfied,
can be modeled as if the individual was maximizing this
utility function.

2. The HARA utility function is given by the following expression:

u ( W )=

W 1
1

a. Prove that the parameter

provides a measure of risk

aversion.
(0.25 points)
b. What can be said about the risk aversion of an individual
1
whose VNM utility function is given by u ( W )=W
?
(0.25 points)

a. Calculate the absolute risk aversion coefficient:

'

u ( W )=W

u' ' ( W ) =W 1

ARA =

u' ' ( W )
=W 1
'
u (W )

And then,
RRA=W ARA =

b. For this utility function

'

u ( W )=W

u' ' ( W ) =2W 3

ARA =

u' ' ( W )
=2W 1
'
u (W )

RRA=W ARA =2

The relative risk aversion coefficient is independent of the level of

wealth (CRRA).

3. The skewness of a probability distribution is an indicator of the

asymmetry w.r.t. the mean of the distribution. Positive skewness
indicates that outcomes tend to fall above the mean.
a. In accordance with the Expected Utility Hypothesis, what
were you to conclude if you were told that decision makers

favour investments with high positive skewness?

(0.25 points)
b. What connection can be made with DARA (Decreasing
Absolute Risk Aversion) utility functions, which imply a
decreasing risk premium with increasing wealth?
(0.25 points)

a. Develop the utility function in a Taylor series around a

neighborhood of the expected value of wealth:
u ( W )=u ( E [ W ] ) +u' ( E [ W ] )( W E [ W ] ) +

'''
iv
u' ' ( E [ W ] )
2 u (E[W ])
3 u (E[W ])
( W E [ W ] ) +
( W E [ W ] ) +
(W
2!
3!
4!

Take expectations

E [ u (W ) ] =u ( E [ W ] ) +u' ( E [ W ] ) E [ W E [ W ] ] +

u' ' ( E [ W ] )
u' '' ( E [ W ] )
2
3
E [ ( W E [ W ] ) ] +
E [ ( W E [ W ] ) ] +
2!
3!

The last term is the product of the third derivative of the utility
function times the third central moment, which is a measure of
skewness (it is zero for symmetric distributions). If investors are
interested in investments with positive skewness, then that means
that skewness adds to their expected utility. Therefore, the third
derivative must be positive.
b. What does DARA imply?
' ''
'
''
''
dARA u ( W ) u ( W )+u (W ) u ( W )
=
<0
2
dW
[ u' ( W ) ]

The denominator is positive and the rightmost term in the

numerator is also positive (risk aversion). Since the first
derivative is positive (no satiation), the only way for this

expression to be negative is in the case of a positive third

derivative of the utility function. So we see that DARA is related
with a preference for positive skewness.

4. Show that, according to the Expected Utility Hypothesis, a convex

VNM utility function describes the behavior of a risk-lover
individual.
(1.0 points)
A risk-averse individual is willing to pay to avoid a fair game.
Conversely, a risk-seeking individual is willing to pay in order to
participate in a fair game (enjoys the game). Risk seeking is
equivalent to convexity of the utility function (according to the
EUH). Therefore, if he/she is better off taking the game, then we
must have
E [ U (W + ~) ] >U (W )
Analytically:
Go to page 23 in Appendix 1 and reverse the argument.
Geometrically:

U ( W + 1) tan ( ) 1=U ( W + 1 )

1
1

U ( W + 1) U ( W + 2 ) ) =
U ( W + 1 ) 1 U ( W + 2 )
(
1 2
1 2
1 2

5. Imagine that Derek Fisher and Kevin Durant are both in the same
situation. The two of them possess 4,000 ducats each in their
respective homes, and each have merchandise in some foreign
country valued in 8,000 ducats. This merchandise can only be
brought home by sea (KD and DF will hire separate vessels) and
the probability that the vessel transporting the merchandise sinks
is 50% (with 50% probability one particular vessel might sink and
then
the
merchandise
will
be
lost).
The probability that one vessel sinks is independent of the
probability that the other vessel sinks.

If Derek Fishers utility function is given by

Durants utility function is given by

ln ( W )

and Kevin

W , find their respective

certainty equivalents and reason who is more risk-averse, either

KD or DF.
(1.0 points)
Derek Fishers certainty equivalent is:

1
1
ln ( 4,000 ) + ln ( 12,000 )=8.8434=ln ( 6,928.5 )
2
2

6,928.54,000=2,928.5

Kevin Durants certainty equivalent is:

1
1
4,000+ 12,000=86.395=7,464.1
2
2

7,464.14,000=3,464.1

As Derek Fisher is willing to accept a smaller payment with

certainty so as to get rid of the risk, then he must be more riskaverse tan Kevin Durant (the graph of the log function is has more
concavity than that of the square root function).

6. In the stock market of Midgard there exist two risky securities A

and B. A particular investor in this market has projected the
following characteristics for these stocks:
E [ R A ] =14 , A =24
E [ RB ] =20 , B=50
A ,B =0.9

There also exists a riskless treasury instrument (bill) available for

investors of Midgard. The expected return or implied interest rate
on this bill is 10%.
You are requested to find:
a. The equation of the Capital Market Line (name given to the
efficient frontier when all investors share the same beliefs).
(1.5 points)
b. The expected return of the tangency portfolio and its
standard deviation.
(1.0 points)

SEE SPREADSHEET ATTACHED

SOME 5x5 MATRICES AND THEIR INVERSES

0,05
76
0,00
9
0

0,00
9

0,25

-0,14

-0,2

0
0,
1

-1

-1

-1

0,05
76 -0,09

-0,09

0,25

-0,14

-0,2

0
0,
1

-1

-1

0,05
76 -0,09

0,1
4
0,2
0
0,1
0

9,5420

3,816
8

3,8168

1,526
7

5,7252

10,400
8

2,2901

5,8397

1,040
1
0,584
0
2,624
0

5,7252
10,400
8

1,0401

2,290
1
5,839
7
0,584
0

-1

5,8962

2,358
5

3,5377

11,202
8

-1

2,3585

0,943
4

1,4151

5,5189

3,5377
11,202
8

1,415
1
5,518
9

2,1226

16,721
7

16,721
7

3,7146

1,1203

0,551
9

2,6722

0,3715

0,371
5
0,037
1

1,7587

0,703
5

1,0552

8,3539

0,835
4

0,1
4
0,2
0
0,1
0
0

-1

0,1
4

-1
0
0

-1

16,240
5

16,240
5
13,663
2

2,6240

1,3663

0,136
6

1,120
3

3,4351

1,366
3

0,551
9
2,672
2

-0,09

0,25

0
0,
1

-0,2 -0,14
-1

-1

-1

0,01
8

0,5

-0,14

-0,2

0
0,
1

0,11
52
0,01
8

-1

-1

0,05
76 -0,09

-1

-0,09

0,25

-0,14

-0,2

0
0,
1

-1

-1

0,05 -0,09

0,2
0
0,1
0

-1

1,758
7
1,055
2
4,970
1

2,6381

4,1154

1,5828

12,469
2

17,544
8

2,7700

2,7545

0,2770

0,277
0
0,027
7

1,040
1

2,6381
12,574
7

1,2575

0,497
0

-1

4,7710

1,908
4

2,8626

10,400
8

-1

1,9084

0,763
4

1,1450

5,8397

2,8626
10,400
8

1,145
0
5,839
7

1,0401

0,584
0

-1

5,8962

2,358
5

-1

2,3585

0,943
4
1,415
1
5,518
9

0,1
4
0,2
0
0,1
0
0
0

0,1
4
0,2
0
0,1
0

-1

4,3968

-1
0
0

0,411
5
2,246
9

0,584
0
2,624
0

16,240
5

16,240
5
27,326
3

2,6240

2,7326

2,732
6
0,273
3

3,5377

11,202
8

1,120
3

1,4151

5,5189

2,1226

16,721
7

16,721
7

3,7146

1,7176

0,551
9
2,672
2

3,5377
11,202
8

-1

1,1203

0,551
9

2,6722

0,3715

0,371
5
0,037
1

-1

2,4374

0,771

-1

76
-0,09
0

0,25
0

-0,2 -0,16
-1

-1

0
0
0,
1
-1

-1

4,0624

1,625
0
0,650
0
5,060
1

7,7186

2,4374

3,8024

0,9750

11,521
0

0,380
2
2,152
1

17,409
8

2,5593

1,6250
12,349
7

1,2350

0,506
0

2,7410

0,2559

0,255
9
0,025
6

-1

4,7710

1,908
4

2,8626

10,400
8

1,040
1

-1

1,9084

0,763
4

1,1450

1,145
0
5,839
7

1,7176

5,8397
16,240
5

0,584
0
2,624
0

16,240
5

27,326
3

0,14

0,2

0,
1

-1

-1

-1

1,0401

0,584
0

2,6240

2,7326

-1

4,7710

1,908
4

2,8626

10,400
8

-1

1,9084

0,763
4

1,1450

5,8397

1,145
0
5,839
7
0,584
0

0,5

-1

1,4625

2,8626
10,400
8

0,11
52
0,01
8

0,975
0

0,1
4
0,2
0
0,1
0

0,11
52
0,01
8

0,01
8

0,1
4
0,2
0
0,1
0

0,01
8

0,5

-0,14

-0,2

0
0,
1

0,1
4
0,2
0
0,1
0

-1

2,8626
10,400
8

1,0401

-1

1,7176
16,240
5
2,6240

16,240
5
27,326
3
2,7326

2,732
6
0,273
3

1,040
1
0,584
0
2,624
0
2,732
6
0,273
3

0,11
52
0,01
8

0,01
8

4,7710

1,908
4

2,8626

10,400
8

-1

1,9084

0,763
4

1,1450

0,1
0

-1

2,8626

1,145
0

0,
1

10,400
8

5,839
7

1,7176
16,240
5

5,8397
16,240
5
27,326
3

-1

1,0401

0,584
0

2,6240

2,7326

0,584
0
2,624
0
2,732
6
0,273
3

-1

1,4984

0,599
3

0,8990

8,1660

0,816
6

-1

3,7459

2,2475

4,5850

0,458
5
2,275
1

0,1
4

-1

0,5

0,2
0

0,14

0,2

-1

-1

0,11
52
0,01
8
0

0,01
8

0,5

0
0,
1

-0,2 -0,14
-1

-1

-1

0,1
4
0,2
0
0,1
0

-1

2,2475
18,999
1

1,8999

1,498
4
0,899
0
2,400
4
0,240
0

1,3485
21,399
5

12,751
0
21,454
9

3,1399

2,1455

1,040
1

2,145
5
0,214
5