Scribd
Upload
10 views

Financial Economics - Group 2: Problem Set 2

This document contains 5 problems related to financial economics. Problem 1 involves calculating certainty equivalents for casino games using two utility functions. Problem 2 analyzes risk aversion coefficients and classifies utility functions. Problem 3 examines certaintly equivalents and insurance for gambles. Problem 4 optimizes expected utility for an agent facing an insured loss. Problem 5 considers portfolio optimization between a risky and risk-free asset.

Uploaded by

Luigi Pastrana Rosario
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
10 views

Financial Economics - Group 2: Problem Set 2

This document contains 5 problems related to financial economics. Problem 1 involves calculating certainty equivalents for casino games using two utility functions. Problem 2 analyzes risk aversion coefficients and classifies utility functions. Problem 3 examines certaintly equivalents and insurance for gambles. Problem 4 optimizes expected utility for an agent facing an insured loss. Problem 5 considers portfolio optimization between a risky and risk-free asset.

Uploaded by

Luigi Pastrana Rosario
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 2

Financial Economics - Group 2

Problem Set 2

1. Calculate the certainty equivalent of the√casino game in the St. Petersburg paradox for the
utility functions u(x) = ln x and u(x) = x.
2. Consider the following utility functions
(a) u(x) = − x1
(b) u(x) = ln(x)
(c) u(x) = −x−γ
xγ
(d) u(x) = γ
(e) u(x) = ax − bx2
For each utility function
i. Find the set of parameters that ensure u0 > 0 and u00 < 0
ii. Calculate the (Arrow-Pratt) absolute and relative risk aversion coefficients

u00 (x)
ARA(x) := −
u0 (x)
xu00 (x)
RRA(x) := − 0
u (x)

What is the effect of the parameters on these coefficients?


iii. Classify the functions as increasing, decreasing or constant risk-aversion utility functions
(both absolute and relative).
√
3. Suppose an individual with zero initial wealth and utility function u(x) = x is offered the
gamble that pays either $4 or $16, both payoffs with the same probability.
(a) What is the certainty equivalent for this gamble?
(b) Suppose there is an insurance policy that pays −$6 if the gamble pays $16, and $6 if the
gamble pays $4. What is the maximum that the individual should be willing to pay for
this insurance policy?
(c) What is the minimum required increase in the probability of the high-payoff state so that
the individual will not be willing to pay any premium for such an insurance policy?
(d) Suppose now that the gamble that pays either $16 or $36, both payoffs with the same
probability, and the insurance pays −$10 if the gamble pays $36, and $10 if the gamble
pays $16.
Repeat questions (a)-(c) for this new gamble. Is the required increase in probability
smaller, larger, or the same? Why?
4. An agent with logarithmic utility function of wealth tries to maximize his expected utility.
The agent faces a situation in which may incur a loss L with probability p.
The agent has the possibility to insure against this loss. The insurance premium on the extent
of the coverage. The amount covered is denoted by α and the price of the insurance per unit
coverage is q. That is, the amount the agent spends on insurance is αq.

1
(a) Calculate the amount of coverage α∗ demanded by the agent as a function of the agent’s
initial wealth v, the loss L, the probability p and the price of insurance q.
(b) What is the expected gain (i.e. expected revenue - expected cost) for an insurance
company offering such a contract?
(c) What amount of insurance α∗ will the agent buy if the insurance company sets the price
q for a zero expected gain? Does the form of the utility function affect this?
(d) Suppose now the insurance company charges a premium q > p. Let v = 10000 and
p = 1%. For
q ∈ {1.05%, 1.10%, 1.15%, 1.20%, 1.25%}
Calculate the minimum loss L for which the agent would be willing to buy insurance.

5. Consider an economy with two financial assets: one-risk free asset and one risky asset. We
denote
r1 = rate of return of risky asset
r0 = rate of return of risk-free asset
v = Initial wealth
A = Amount of wealth invested in the risky asset
We assume E[r1 ] > r0 and agents are risk-averse.

(a) Write down an expression for final wealth V as a function of v, A, r1 and r0 .


(b) Compute the first and second order conditions of the expected utility maximization prob-
lem
max E[u(V )]
A≥0

(c) In what follows assume ARA0 (x) < 0. Prove the inequality

u00 (v(1 + r0 ) + A(r1 − r0 ))(r1 − r0 ) ≥ −ARA(v(1 + r0 ))u0 (v(1 + r0 ) + A(r1 − r0 ))(r1 − r0 )

Hint: Consider separately the cases r1 ≥ r0 and r1 = r0 .


(d) Show that
E[u00 (v(1 + r0 ) + A(r1 − r0 ))(r1 − r0 )] > 0.
Hint: Use the previous inequality and the FOC.
(e) Let A∗ be the optimal amount of wealth to be invested in the risky asset. Determine the
sign of dA∗ /dv.

You might also like