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8-Discussion Questions

# 8-Discussion Questions - Lecture 8 Uncertainty(II Textbook...

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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? 7. When is it worth paying to obtain more information to reduce uncertainty? 8. How does the diversification of an investor’s portfolio avoid risk? 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. Probability Return .999 -\$1,000,000 (he fails) .001 \$1,000,000,000 (he succeeds and sells the formula) a. What is the expected return of his project? What is the variance? b. What is the most Sam is willing to pay for insurance? Assume Sam is risk neutral. c. Suppose you found out that the Japanese are on the verge of introducing their own mayonnaise substitute next month. Sam does not know this and has just turned down your final offer of \$1,000 for the insurance. Assume that Sam tells you SCAM is only six months away from perfecting its mayonnaise substitute and that you know what you know about the Japanese. Would you raise or lower your policy premium on any subsequent proposal to Sam? Based on his information, would Sam accept?

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8. As the owner of a family farm whose wealth is \$250,000, you must choose between sitting this season out and investing last year’s earnings (\$200,000) in a safe money market fund paying 5.0% or planting summer corn.
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