B AYLOR U NIVERSITY H ANKAMER S CHOOL OF B USINESS D EPARTMENT OF F INANCE , I NSURANCE R EAL E STATE Dr. Garven Name ____________________ Problem Set #4 1. Consider two risky prospects, X l and X 2 , with payoffs given by: 1 0 with probability .25 10 with probability .50 20 with probability .25 X and 2 0 with probability 1/3 10 with probability 1/3 20 with probability 1/3 X Assume that your initial wealth ( W0 ) is $0, and your utility U ( W ) = W . A. Is either prospect preferred to the other according to first or second order stochastic dominance? B. Is either prospect preferred to the other according to the mean-variance rule? C. Is either prospect preferred to the other according to the expected utility rule? D. Which prospect do you prefer? Why? 2. Consider a risk averse investor with utility function U ( W ) = W who is deciding how much of her initial wealth ( W0 ) to invest in a bond and how much to invest in a stock. The current prices
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