Question 1

Anika and Anthony are offered a choice between options A and B:

A: Lottery X=(0.5,$100;0.5,$20). This is a gamble with a 50% chance of winning $100 and a 50% chance of winning $20.

B: $40 for certain.

(a) Anika is risk-neutral. Will Anika choose A or B? (1 mark)

(b) Anthony is risk averse with wealth $100 and utility function U(X) = ln(X). Will Anthony choose A or B? (1 mark)

(c) Draw a graph showing the choices faced by Anthony, his utility curve and the expected utility of each option. Indicate the certainty equivalent of option A. Explain how the graph shows which option Anthony will choose. (4 marks)