FIN367 S08Exam2B - FIN 367: Spring 2008 Test # 2: Portfolio...

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FIN 367: Spring 2008 Test # 2: Portfolio Theory March 5, 2008 NAME: SECTION: Time allowed: 1 hour, 15 minutes. Maximum possible score: 100. NOTE: If I cannot understand your calculations, I will not be able to give you full credit even if your Fnal answer is correct. You cannot say “these calculations are obvious.” If a problem is missing some key information that you think is necessary to solve the problem, please ask me to clarify the question or state your confusions clearly. Alternatively, please make appropriate assumptions, state them clearly and proceed. No credit will be awarded if you fail to state your confusions or assumptions explicitly even if the question is wrong . Partial credits may be awarded if you show your calculations or provide arguments to support your answers. 1
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Certainty Equivalent (10 points, 10 minutes) Suppose the economy can be in one of the following two states: (i) Boom or “good” state and (ii) Recession or “bad” state. The good state occurs with a probability of 2/3 and the bad state could occur with a probability of 1/3. An investor with an initial wealth of $70 is evaluating a gamble with the following net payofs: $15 in the good state and - $30 in the bad state. Assume that the utility function of an investor with wealth level W is u ( W ) = 2 W. 1. (5 points) Compute the certainty equivalent (CE) and the insurance premium of the gamble. Show your calculations clearly. 2. (5 points) Draw the utility function of the investor who holds this gamble. Show the following points on the utility graph very clearly: (i) utility from the wealth in the “bad” state, (ii) utility from the wealth in the “good” state, (iii) expected utility from the uncertain wealth in the future, (iv) certainty equivalent, and (v) the insurance premium. Please label the graph clearly. 2
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This note was uploaded on 03/30/2010 for the course CH 369 taught by Professor Kbrowning during the Spring '07 term at University of Texas at Austin.

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FIN367 S08Exam2B - FIN 367: Spring 2008 Test # 2: Portfolio...

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