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Problem 2. Certainty Equivalent and Risk Premium. Suppose an individual with zero initial wealth and utility function u(W) W is confronted with the gamble (16,4,0.5)
Problem 2. Certainty Equivalent and Risk Premium. Suppose an individual with zero initial wealth and utility function u(W) W is confronted with the gamble (16,4,0.5) (i.e., it pays off 16 with probability 0.5 and 4 with probability 0.5) 1. What is the certainty equivalent for this gamble? 2. Suppose there is an insurance policy that pays off -6, if the gamble pays off 16, and 6 if the gamble pays off 4. What is the maximum that the individual should be willing to pay for this policy? 3. What is the minimum required increase in the probability of the high-payoff state so that the individual will not be willing to pay any premium for such an insurance policy? 4. Now suppose the individual is faced with the gamble (36, 16,0.5). In this case, assume the insurance policy pays off -10, if the gamble pays off 36, and 10 if the gamble pays off 16. Repeat points 1-3 for this new gamble. Is the required increase in probability smaller, larger, or the same as for the first gamble? Why
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