SOLUTION PS10

SOLUTION PS10 - Solution PS #10 Problem 1 Every dollar...

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Solution PS #10 Problem 1 an entirely independent business with returns that are uncorrelated with those of Go For Broke, Inc. For it too, every dollar invested in Shoot the Moon, Inc. will return $3 with probability one-half and $0 with probability one-half. Maria starts out with $300 and seeks to maximize her expected utility, where her utility is given by when she has X dollars. She has three options: keep the $300, invest it all in Go For Broke, Inc. or invest $150 each in Go For Broke, Inc. and in Shoot the Moon, Inc. Compute the certainty equivalent of each option. Which is best for Maria? What is the bene²t of diversi²cation to Maria in terms of dollars of certainty equivalent? Solution 2 Option 1: keeping all the money, will give her p 300 17 : 3 exp ected utils: Option 2:Spending it all in Go For Broke gives her 0.5 p 900 = 15 expected utils. Option 3: Spending half in Go For Broke and half in Shoot the Moon, gives her 0.25 p 900 + 0 : 25 p 450 + 0 : 25 p 450 + 0 : 25 p 0 = 18 : 1 : The certainty equivalent of Option 1 is 300 (since there is no risk involved). The certainty equivalent of Option 2 is 225. The certainty equivalent of option 3 is 328. The best for Maria is to diversify (option 3). The bene²t of diversi²cation (i.e. the di/erence between option 3 and option 2) is of 103 certain dollars
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This note was uploaded on 07/09/2008 for the course ECO 100 taught by Professor R.willig during the Spring '08 term at Princeton.

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SOLUTION PS10 - Solution PS #10 Problem 1 Every dollar...

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