8-Discussion Questions - Solutions

8-Discussion Questions - Solutions - Lecture 8: Uncertainty...

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Lecture 8: Uncertainty (II) Textbook sections covered 5.2 and 5.3 Suggested questions and exercises (Pindyck and Rubinfeld, Ch.5). Questions: 6, 7, 8 Exercises: 5, 8, 10, 11 Additional exercises (Based on Past Midterms and Finals). 1- Selling Music to an Uncertain Demand. 2- Project choice in the Umbrella Corporation. QUESTIONS 6. Why is an insurance company likely to behave as if it is risk neutral even if its managers are risk-averse individuals? Most large companies have opportunities for diversifying risk by insuring risks that are negatively correlated. Moreover, by operating on a sufficiently large scale, the law of large numbers implies that insurance companies can assure themselves that over many outcomes the total premiums paid to the company will be equal to the total amount of money paid out to compensate the losses of the insured with diminishing variability. Thus, the insurance company behaves as if it is risk neutral, while the managers, as individuals, might be risk averse. Of course, shareholders may diversify their risk by investing in several projects in the same way that the insurance company itself diversifies risk by insuring many people 7. When is it worth paying to obtain more information to reduce uncertainty? Individuals are willing to pay for more information when the utility of the choice with more information, including the cost of gathering the information, is greater than the expected utility of the choice without the information. A necessary condition for information to be valuable is that the choice made will depend on the information obtained (e.g. if I would go to see a movie no matter the reviews, I have zero value for the reviews). 8. How does the diversification of an investor’s portfolio avoid risk? An investor reduces risk by investing in many negatively correlated assets. For example, a mutual fund is a portfolio of stocks of independent companies. If the variance of the return on one company’s stock is inversely related to the variance of the return on another comp any’s stock, a portfolio of both stocks will have a lower variance than either stock held separately. As the number of stocks increases, the variance in the rate of return on the portfolio as a whole decreases. While there is less risk in a portfolio of stocks, risk is not eliminated altogether; there is still some market risk in holding such a portfolio, compared to a low-risk asset, such as a U.S. government savings bond.
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EXERCISES 5. You are an insurance agent who has to write a policy for a new client named Sam. His company, Society for Creative Alternatives to Mayonnaise (SCAM), is working on a low-fat, low-cholesterol mayonnaise substitute for the sandwich condiment industry. The sandwich industry will pay top dollar to whoever invents such a mayonnaise substitute first. Sam’s SCAM seems like a very risky proposition to you. You have calculated his possible returns table as follows.
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8-Discussion Questions - Solutions - Lecture 8: Uncertainty...

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