Problem Set 2 Suggested Solutions
Ec 1723 - Fall 2018
1. Suppose that your wealth is $900,000. You buy a $700,000 house and invest the re-
mainder in a risk-free asset paying an annual interest rate of 1%. There is a probability
of 0.002 that your house will burn to the ground and its value will be reduced to zero.
The real estate market is (uncharacteristically) stable, so if your house does not burn
down, its value will still be $700,000 at the end of the year.
(a) Consider a fire insurance policy that pays you $700,000 at the end of the year if
your house burns down.
If you have log utility of end-of-year wealth, what is the
most that you would be willing to pay for this insurance policy at the beginning
of the year?
(Remember to use natural logarithms in this and all other contexts
where the word “log” is used in this course.)
(b) What is your relative risk aversion in the log case?
How would your previous
answer change if you had a higher relative risk aversion coefficient?