Additional Exercises

Risk and Risk Aversion

Honours IMF / Advanced Micro
Compiled by Andrew Duncan
1. Suppose that you are exposed to a 50/50 probability of gaining or losing R1; 000. An insurance contract
that removes your risk costs R500. Assume that your utility function is u(W) =
1
W
. At what level
of wealth will you be indierent between taking the gamble or paying the insurance?
2. Assume that your utility function is u(W) = lnW and that you are faced with a 50/50 probability of
winning or losing R100.
(a) How much will you pay to avoid this risk if your current level of wealth is R1; 000? (Hint: if
lnc
L
= x, then c
L
= e
ln c
L
= e
x
; where e is the exponential function)
(b) Without recalculating the risk premium, comment on how you would expect the amount calculated
in part (a) to change if your preferences were given by v (W) =
p
W. Motivate your answer.
(c) How much would you pay if your utility is given by u and if your current level of wealth is
R10; 000?
(d) Did you expect that the premium you were willing to pay would increase, decrease or stay the
same in part (b)? Why?
3. Suppose that an investor has preferences described by the utility function
u(W) =
W

; (*)
where W denotes wealth and > 0 is some constant.
(a) What is the dening property of a strictly risk averse investor (your denition must be expressed
in terms of lotteries)?
(b) Discuss in detail the nature of the preferences that are implied by equation (*). Show appropriate
calculations to support your answer.
(c) Assume that the investor has initial wealth A = 500. Let = 0:5. Consider the lottery
L := (A+ 50; A100; 0:6) .
1. Is L a fair lottery? Why?
2. Calculate u(Y ).
3. Calculate the expected utility of L.
4. What can we conclude from the above calculations if the investor has the option of playing
L for free?
5. Showing all calculations, calculate the investors certainty equivalent c
L
for L.
6. Calculate the investors risk premium rp
L
for L.
7. Interpret the values that you calculated for rp
L
and c
L
.
(d) Suppose that we change the investors utility function to
u
0
(W) = lnW:
Assume that A, , and L are unchanged from part (c). Let rp
0
L
denote the risk premium implied
by u
0
. Without calculating rp
0
L
, comment on its size relative to rp
L
. Motivate your answer.
4. (Modied question from Danthine and Donaldson 2005) An agent with utility function
u(W) =
p
W
is confronted by the lottery
L = (16; 4; ) .
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(a) Assume that =
1
2
. What is the agents certainty equivalent c
L
for L?
(b) Let =
1
2
. Assume that there is an insurance policy which guarantees that the agent will receive
E (L). Suppose that the premium on the insurance policy is 2.
1. Describe the cash-ows that are associated with the insurance policy from the perspective of
the agent and from the perspective of the insurance company.
2. Is it optimal for the agent to insure? Motivate your answer.
(c) Answer part (b.2.) again, this time assuming that the agents utility function is given by
v (W) =
1
W
:
(d) Explain the dierence (if any) between your answers to parts (b.2.) and (c).
(e) Calculate the value for such that rp
L
= 0. Assume that the agents preferences are captured
by utility function u.
(f) Repeat parts (a) to (e) for the lottery
L
0
= (36; 16; ) .
Explain what is going on, and why?
Solutions to Selected Questions
It is important that you attempt to solve the problems in this worksheet independently. I will provide
selected answers on Edulink by Tuesday 19 March.
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