Consider Richard has the following value function under prospect theory: v(w) w when w>0 =-2(-w) when...
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Consider Richard has the following value function under prospect theory: v(w) w when w>0 =-2(-w) when w<0 Richard is deciding whether to buy a state lottery ticket. Each ticket costs $1, and the probability of the following winning payoffs is given as follows: Probability 0.50 0.25 0.20 0.05 Return $0.00 $1.00 $2.00 $7.50 7.1 Is this individual loss-averse? Explain. What is the difference between loss aversion and risk aversion? (4 points) 7.2 Would Richard buy the ticket? (6 points) 8 Question worth 10 points An investor is confronted with the following investment possibilities: today 1 year 2 years Bond: rises 1.04 1.02 rises falls rises falls 0.98 Bond: rises 1.04 1.02 rises falls rises falls 0.98 falls 0.96 rises 1.21 1.1 rises Shares: falls rises 1.03 falls 0.94 falls 0.88 the probabilities for "rises" and "falls" are identical (= 0.5). Mike is a "Prospect Theory"-investor with a value function as proposed by Kahneman and Tversky and his reference point is his initial wealth (The interest rate factor is assumed to be 1+1=1). His utility function is: |u(x)= {-A- \-B(-x) if x≥0 if x<0 where α=0.88 . Please use the interest rate factors provided above for the calculation of the x (e.g. 1; 1.02; 1.04) Which investment (bonds or shares) would Mike prefer if he had a one year investment horizon? Which investment would he prefer if he had a two year horizon? Assume ẞ-2. Explain the results. (10 points) Consider Richard has the following value function under prospect theory: v(w) w when w>0 =-2(-w) when w<0 Richard is deciding whether to buy a state lottery ticket. Each ticket costs $1, and the probability of the following winning payoffs is given as follows: Probability 0.50 0.25 0.20 0.05 Return $0.00 $1.00 $2.00 $7.50 7.1 Is this individual loss-averse? Explain. What is the difference between loss aversion and risk aversion? (4 points) 7.2 Would Richard buy the ticket? (6 points) 8 Question worth 10 points An investor is confronted with the following investment possibilities: today 1 year 2 years Bond: rises 1.04 1.02 rises falls rises falls 0.98 Bond: rises 1.04 1.02 rises falls rises falls 0.98 falls 0.96 rises 1.21 1.1 rises Shares: falls rises 1.03 falls 0.94 falls 0.88 the probabilities for "rises" and "falls" are identical (= 0.5). Mike is a "Prospect Theory"-investor with a value function as proposed by Kahneman and Tversky and his reference point is his initial wealth (The interest rate factor is assumed to be 1+1=1). His utility function is: |u(x)= {-A- \-B(-x) if x≥0 if x<0 where α=0.88 . Please use the interest rate factors provided above for the calculation of the x (e.g. 1; 1.02; 1.04) Which investment (bonds or shares) would Mike prefer if he had a one year investment horizon? Which investment would he prefer if he had a two year horizon? Assume ẞ-2. Explain the results. (10 points)
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71 To determine if Richard is lossaverse we need to compare how he values gains and losses According to the prospect theory value function provided Ri... View the full answer
Related Book For
Behavioral Finance Psychology Decision-Making and Markets
ISBN: 978-0324661170
1st edition
Authors: Lucy Ackert
Posted Date:
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