Question
Question 1 Consider a risk averse individual who has utility function u(a) which is increasing with u(0) = 0. There is one safe asset which
Question 1 Consider a risk averse individual who has utility function u(a) which is increasing
with u(0) = 0. There is one safe asset which gives $1 for every dollar invested. There are two
risky assets: A,B. For A, every dollar invested gives return $0 with probability 4/5 and $3 with
probability 1/5. For B, every dollar invested gives return is $0 with probability 2/3 and $3 with
probability 1/3.
The individual has $60 to invest. Out of $60, the individual must invest $30 in the safe asset and
the remaining $30 can be invested in risky assets. Consider two investment choices: (1) invest
entire $30 in A and (2) invest $15 in A, $15 in B.
(a) [4 points] Drawing diagram of the utility function and showing your work, determine the
expected utility of the individual from choice 1.
(b) [4 points] Drawing diagram of the utility function and showing your work, determine the
expected utility of the individual from choice 2 when return from A is bad.
(c) [4 points] Drawing diagram of the utility function and showing your work, determine the
expected utility of the individual from choice 2 when return from A is good.
(d) [4 points] Drawing diagram of the utility function and showing your work, determine the
expected utility of the individual from choice 2.
(e) [4 points] Comparing expected utility from choices 1,2 in a diagram, determine which choice
is better.
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