rates of return Ralph is contemplating loaning a eousin $10,000. The loa n would be due in one year, with interest at 18%. Ralph figures the probability the cousin will pay back the loan (pIus interest) is .80; with probability .10 only the principal will be paid back; and with probability .10 nothing will be paid by the cousin. Ralph' s next best use of the $10,000 is to invest it at the risk free rate of 4%. Ralph is risk neutraI and anaIyzes this in the following fashion. The expected retum from the cousin is 10,000(1.18)(.8) + 10,000(.1) + 0(.1) = 10,440. So the funds can be invested at 4%

or at 4.4%. The latter is a winner.

Carefully discuss how Ralph has used the principles of consistent framing in reducing this to a comparison of interest rates. As a starting point, assume Ralph's preferences are measured by the present value of expected wealth, and Ralph has a variety of investments in place.

AppendixLO1