FIN367 S08Exam2B

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

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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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