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ECON6015 Finance
EXERCISE 1 - Notes on Answers mpton Note that these are outline answers only - full answers will include definitions and expla- nations as appropriate. 1. VEVOX exercises (a) True/False: You are told that U(W ) = W 2 is a utility function with dimin- ishing marginal utility. Outline answer: False. For a utility function to exhibit diminishing marginal utility, the second derivative of the utility function must be negative. (b) A person has an expected utility function of the form U(W ) = √ W . He initially has wealth of $ 4. He has a lottery ticket that will be worth $12 with probability 0.5 and will be worth $ 0 with probability 0.5. i. What is his expected utility? What is the value of certainty equivalent wealth? What is the value of risk premium? Outline answer: EU=0.5(U(12+4))+0.5U(4+0)=3; U(Wce)=3, Wce = 9 E(W)= 0.5*16+0.5*4 = 10 Risk premium = E(W)-Wce=1 2. Find the coefficients of relative risk aversion for the following utility functions where W denotes the investor’s wealth and β > 0. (a) U(W ) = 1− e−βW β Outline answer: U(W ) = 1− e−βW β U ′(W ) = e−βW U ′′(W ) = −βe−βW ρr = −WU ′′(W ) U ′(W ) = βW (b) U(W ) = W 1−β − 1 β − 1 1 Outline answer: U(W ) = W 1−β − 1 β − 1 U ′(W ) = −W−β U ′′(W ) = βW−β−1 ρr = −WU ′′(W ) U ′(W ) = β 3. Rank the following risky investment projects based on stochastic dominance. Project A Project B Project C Payoff Probability Probability Probability 5 0.2 0 0.1 10 0.4 0.1 0.4 20 0.4 0.5 0.2 30 0 0.4 0.2 40 0 0 0.1 Outline answer : You should define all notation, FSD, SSD etc. and arrange your calculations of FA(X), ∫ FA(X)dX etc. in a table. From the table, note that FB(X) ≤ FA(X) and FC(X) ≤ FA(X) for all X ∈ [5, 40], so that Project B and Project C each FSD Project A. Comparing Projects B and C, FB(X) and FC(X) intersect, so neither B nor C FSD the other. However, observe that ∫ FB(X) dX ≤ ∫ FC(X) dX for all X ∈ [5, 40], so B SSD C. In conclusion, Project B SSD Project C, both of which FSD Project A.