Muskan Valbani

PGP/24/456

Question 3
PROBABILITY RETURN ($)
0.5 0
0.25 1
0.2 2
0.05 7.5

a) Expected Value of returns is the total of the individual scenario returns weighted by their
probability of occurrence
So, EV = [(0.5)*0] + [(0.25)*1] + [(0.2)*2] + [(0.05)*7.5] = $1.025
This is the expected value of returns

Variance total of squared deviations of each individual return figure from the expected value
weighted by probabilities
EV = 1.025
So, Variance = [(0.5)*(0-1.025)^2] + [(0.25)*(1-1.025)^2] + [(0.2)*(2-1.025)^2] +
[(0.05)*(7.5-1.025)^2] = 2.811875
(or Standard deviation = 1.6768)
b) If Richard is extremely risk averse, his utility curve for his wealth can be represented as the
following equation:
U = (W)^0.5
Let’s assume his W = $10
Cost of lottery ticket = $1
Wealth possibilities = 9 (10-1), 10 (10-1+!), 11(10-1+2) and 16.5 (10 -1 +7.5)
Expected Utility is the sum of all these wealth possibilities weighted against their
probabilities
Expected utility = (0.5)(9)^0.5 + (0.25)(10)^0.5 + (0.2)(11)^0.5 + (0.05)(16.5)^0.5
=3.157
But Utility of no lottery = 10^0.5 = 3.16
Since utility of wealth without buying the ticket is more, Richard will bot buy the ticket. This
happens because although the EV > Cost of ticket it wasn’t good enough to make Richard
take the risk.
c) Given Richard has 1000 tickets free of any cost, his expected value of payoffs = ev*number
of tickets; 1.025 *!000 = 1025. But the range of payoffs lie far away from expected value and
that would be 0 payoffs if none of the 1000 tickets generates a return to a payoff of 7500 if all
the tickets generate the 7.5 return.
Richard would be willing to sell all the tickets for less (and perhaps considerably less) t
han the expected payoff of $1025. More precisely, he would sell the tickets for $1025 minus his
risk premium.
d) Since the expected value is greater than the cost of the lottery, at these levels of probabilities
the state is bound to lose money by the extent to which expected value exceeds price; $0.025
per ticket sold.
Better options could be for state to increase prices of the lottery, change probabilities in a way
that lesser probability is assigned to higher returns and more to lesser returns.
 Muskan Valbani
PGP/24/456

Question 5
a) Expected Value of returns is the total of the individual scenario returns weighted by their
probability of occurrence
So, EV = [(0.999)*-1000000] + [(0.001)*1000000000] = $1000
Variance total of squared deviations of each individual return figure from the expected value
weighted by probabilities
So, Variance = [(0.999)*(-1000000-1000)^2] + [(0.001)*(10000000-1000)^2]=
1000998999000000
b) Sam is risk Neutral, UW = W, irrespective of whether it is inusred or uninsured; his expected
return is the same as the guaranteed return with insurance and thus insurance has no value
for Sam and he will not pay anything for it.
c) When the Japanese will introduce their Mayo, the probabilities for a higher payoff for Sam
will reduce
Assuming that the probability of the billion-dollar payoff is cut in half
Expected outcome = 0.9995*(−$1,000,000) + 0.0005*($1,000,000,000) = −$499,500
Therefore, The policy premium should be raised But Sam doesn’t know about the Japanese
entry and hence will continue to refuse the offers to insure his losses.

Question 7
a) INVESTMENT A
Expected Value of returns is the total of the individual scenario returns weighted by their
probability of occurrence
So, EV = [(0.1)*300] + [(0.8)*250] + [(0.1)*200] = $250
This is the expected value of returns

Variance total of squared deviations of each individual return figure from the expected value
weighted by probabilities
EV = 250
So, Variance = [(0.1)*(300-250)^2] + [(0.8)*(250-250)^2] + [(0.2)*(200-250)^2] = 500
Standard Deviation = 500^1/2 = 22.3606

INVESTMENT B
EV = [(0.3)*300] + [(0.4)*250] + [(0.3)*200] = $250
This is the expected value of returns
So, Variance = [(0.3)*(300-250)^2] + [(0.4)*(250-250)^2] + [(0.3)*(200-250)^2] = 1500
Standard Deviation = 1500^1/2 = 38.729

b) Utility Function given for Jill: U = 5I

Considering investment A  Jill’s Expected Utility = 0.1*(5*300) + 0.8*(5*250) + 0.1*(5*200)
= 1250
Investment B  Jill’s Expected Utility = 0.3*(5*300) + 0.4*(5*250) + 0.3*(5*200) = 1250
Both investments give Jill the same Expected Utility and so she will be indifferent between
the two. Jill is risk neutral.
c) U = 5I^1/2
For A, Ken’s Expected Utility = 0.1*(5*3001/2) + 0.8*(5*2501/2) + 0.1*(5*2001/2) = 78.98
For B, Ken’s Expected Utility = 0.3*(5*3001/2) + 0.4*(5*2501/2) + 0.3*(5*2001/2) = 78.82
 Muskan Valbani
PGP/24/456

Ken is risk averse so he will choose the first option where the Expected return is slightly
higher.
d) U = 5I^2
For A, Laura’s Expected Utility = 0.1*(5*3002 ) + 0.8*(5*2502 ) + 0.1*(5*2002 ) = 3,15,000
For B, Laura’s Expected Utility = 0.3*(5*3002 ) + 0.4*(5*2502 ) + 0.3*(5*2002 ) = 3,20,000
Laura is a risk lover so she will choose the second option where the variability is high

Class Question: Find CE for Risk neutral and Risk Lover

ANSWER:
For the lottery given,
Price of Ticket = 10,000
Probability of losing = Pa = 0.99
Probability of winning 10,00,000 = Pb = 0.01

Utility function:
a. U = x2
Expected Utility = (0.99*0)2 + (0.01*10,00,000)2 = 0 + 1010 = 10 billion
CE = x = U1/2 = 1,00,000
b. U = x
Expected Utility = 0.99*0 + 0.01*10,00,000 = 10,000
CE = x = U = 10,000