20. taxes and risk aversion Ralph has been offered an interesting gamble. With probability .5, Ralph will gain $500 and with probability .5 Ralph will gain $100.

The gain is net of the purchase price; also, the possible outcomes are independent of any other items in Ralph’s portfolio.

(a) Suppose Ralph is risk neutral. Determine the gamble’s certainty equivalent.

(b) Ralph remains risk neutral, but faces a constant marginal tax rate of 40%. Determine the gamble’s certainty equivalent. Can Ralph safely ignore taxes in this circumstance?

(c) Now suppose Ralph is risk averse, with a utility measure defined over wealth w of −exp(−ρw) and ρ = .001. Repeat parts (a)

and

(b) above.