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ch11 PDF
ch11 PDF
Expected utility of investment A = 1/3 7.5 + 1/3 12.5 + 1/3 31.5 = 17.0
Expected utility of investment B = 1/4 4.0 + 1/2 17.5 + 1/4 40.0 = 19.75
Expected utility of investment C = 1/5 0.5 + 3/5 31.5 + 1/5 144.0 = 47.8
Expected utility of investment A = 1/3 0.45 + 1/3 0.41 + 1/3 0.33 = 0.40
Expected utility of investment B = 1/4 0.50 + 1/2 0.38 + 1/4 0.32 = 0.39
The investor will prefer the investment that maximizes expected utility of terminal
wealth. Recall that the formula for expected utility of wealth (E[U(W)]) is:
where each P(W) is the probability associated with each particular outcome of
wealth (W). Since U(W ) = W 0.05W 2 , we have:
Investment A:
( ) ( ) ( )
E[U(W )] = 5 0.05 5 2 0.2 + 7 0.05 7 2 0.5 + 10 0.05 10 2 0.3
= 3.75 0.2 + 4.55 0.5 + 5 0.3
= 4.525
Investment B:
( ) ( ) ( )
E[U(W )] = 6 0.05 6 2 0.3 + 8 0.05 8 2 0.8 + 9 0.05 9 2 0.1
= 4.2 0.3 + 4.8 0.6 + 4.95 0.1
= 4.635
To solve this problem, set the expected utility of investment A in Problem 5 equal to
4.635 (the expected utility of investment B) and solve for the value of the first
outcome in investment A:
X 2 20 X + 86 = 0
Roys safety-first criterion is to minimize Prob(RP < RL). If RL = 5%, then (assuming an
initial investment of $100) for the outcomes in Problem 1 we have:
Prob(RA < 5%) = 0.0
4.99% for A
3.99% for B
0.99% for C
Roy's criterion is to minimize Prob(RP < RL). When RL = 3%, Prob(RA < 3%) = 0,
Prob(RB < 3%) = 0, and Prob(RC < 3%) = 0. So, investments A, B, and C are
indistinguishable using Roy's criterion with RL = 3%.