Answered step by step
Verified Expert Solution
Link Copied!

Question

1 Approved Answer

2. Suppose a decision maker lives for two periods, to (today) and , (tomorrow). In period , there are three possible outcomes: . State s,

image text in transcribed
2. Suppose a decision maker lives for two periods, to (today) and , (tomorrow). In period , there are three possible outcomes: . State s, with probability 0.3 (recession). . State $2 with probability 0.4 (normal growth). . State $3 with probability 0.3 (expansion). There are two stocks available to the decision maker, o and B. The stocks yield payoffs according to the following schedule: Stock $1 $2 $3 7 12 14 B 15 5 10 (a) If possible, rank the stocks by the criterion of first order stochastic dominance. Hint: you can use a graph to answer this question. (b) If possible, rank the stocks by the criterion of second order stochastic dominance. Hint: if you made an useful graph from part (a), then you will have a hint about how to proceed. (c) Consider an investor with Bernoulli utility function u(w) = ww. After the investor spends what is needed for consumption at fo, the investor ends up with current wealth of w plus one share of stock a. The investor can either keep the share until next period or sell it now. For simplicity, assume that savings earn a risk free interest rate of zero. i. Suppose w = 10. What is the minimum price the investor would be willing to sell the stock for? Is this more or less than the expected payoff from a? Why? ii. Suppose now that w = 10,000. What is the minimum price the investor would be willing to sell the stock for? How do you explain the difference between this answer and your answer under the previous part? Hint: compute, for any level of wealth, the coefficient of absolute risk aversion of u(w) = w. How does it behave for increasing levels of wealth? Then get inspired by the solutions from problem set 2, (the insurance problem). What do you conclude

Step by Step Solution

There are 3 Steps involved in it

Step: 1

blur-text-image

Get Instant Access to Expert-Tailored Solutions

See step-by-step solutions with expert insights and AI powered tools for academic success

Step: 2

blur-text-image

Step: 3

blur-text-image

Ace Your Homework with AI

Get the answers you need in no time with our AI-driven, step-by-step assistance

Get Started

Recommended Textbook for

What Environmentalists Need To Know About Economics

Authors: Jason Scorse

1st Edition

0230107311, 9780230107311

More Books

Students also viewed these Economics questions

Question

1. To take in the necessary information,

Answered: 1 week ago