The wealth of both investors is 30. You can assume that both investors have zero time preference.

 

Mehra and Prescott find that a plausible equity risk premium consistent with a standard general equilibrium model is far lower than the historically observed risk premium over the past hundred years. This is the so-called equity premium puzzle. In standard neo-classical models, the risk premium is often set equal to the product of the coefficient of relative risk aversion and the covariance between stock returns and consumption growth. Explain why this relationship between consumption growth and stock market returns makes sense. a) Consider two investors: one investor has a rational behavior based on a quadratic utility function U= 0.25*W2, and the other has a utility function based on prospect theory, with Ux=xVx>0 and Ux= 2.5x V x 50. Both investors consider investing their entire wealth in the same stock, which has a 90% probability of increasing with a factor and a 10% probability of decreasing with a factor.