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Risk and Uncertainty Suppose Rita has log utility in wealth,u(w) = ln(w), and has an initial wealth of $40,000. There is a 25% chance that
Risk and Uncertainty
Suppose Rita has log utility in wealth,u(w) = ln(w), and has an initial wealth of
$40,000. There is a 25% chance that she will be healthy this year and her wealth wont be affected by illness. However, there is a 50% chance that she will have a minor illness at some point and a 25% chance that she will experience a major illness. In the case of a minor illness, she will lose $5,000 of her wealth, but a major illness will cost her $30,000.
- What is the expected value of Ritas wealth when she is faced with possible illness, ()?
- What is her utility at that level of wealth, u[E(w)]?
- What is her expected level of utility when faced with potential illness, E[u(w)]?
- Show whether Rita is risk averse, risk neutral, or risk loving.
- What is her certainty equivalent wealth when faced with potential illness?
- What is the risk premium (Markowitz) associated with her potential illness? Interpret this.
- Suppose that she can purchase a health insurance policy that removes the risk entirely (her wealth will remain at $40,000 with certainty). What is the most she will be willing to pay for the insurance policy?
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