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7-Discussion Questions - Solutions

7-Discussion Questions - Solutions - Lecture 7...

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Lecture 7: Uncertainty (I) Suggested questions and exercises (Pindyck and Rubinfeld, Ch.5). Questions: 1, 2, 3, 5 Exercises: 1, 3, 6, 7 QUESTIONS 1. What does it mean to say that a person is risk averse? Why are some people likely to be risk averse, while others are risk lovers? A risk-averse person has a diminishing marginal utility of income and prefers a certain income to a gamble with the same expected income. A risk lover has an increasing marginal utility of income and prefers an uncertain income to a certain income. The economic explanation of whether an individual is risk averse or risk loving depends on the shape of the individual’s utility function for wealth. Also, a person’s risk aversion (or risk l oving) depends on the nature of the risk involved and on the person’s income. 2. Why is the variance a better measure of variability than the range? Range is the difference between the highest possible outcome and the lowest possible outcome. Range does not indicate the probabilities of observing these high or low outcomes. Variance weighs the difference of each outcome from the mean outcome by its probability and, thus, is a more useful measure of variability than the range. 3. George has $5,000 to invest in a mutual fund. The expected return on mutual fund A is 15% and the expected return on mutual fund B is 10%. Should George pick mutual fund A or fund B? George’s decision will depend not only on the expected return for each fund, but also on the variability in the expected return on each fund, and on George’s preferences. For example, if fund A has a higher standard deviation than fund B, and George is risk averse, then he may prefer fund B even though it has a lower expected return. If George is not particularly risk averse he may choose fund A even if it subject to more variability in its expected return. 5. Why do people often want to insure fully against uncertain situations even when the premium paid exceeds the expected value of the loss being insured against? If the cost of insurance is equal to the expected loss, (i.e., if the insurance is actuarially fair), risk-averse individuals will fully insure against monetary loss.
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