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tutorial 9 - TUTORIAL 9 WEEK 10 ECON3107/ECON5106 Economics...

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TUTORIAL 9– WEEK 10 ECON3107/ECON5106 – Economics of Finance 1. (Expected utility) Suppose you are faced with the following gamble scenario: Consume 6000 with probability 0.4 Consume 3000 with probability 0.6. Suppose further that your utility function is of the CRRA (constant relative risk aversion) class: U ( c ) = c 1 - γ 1 - γ , where coefficient of relative risk aversion γ = 1 / 2 . (a) What is your expected utility? (b) What is your expected level of consumption? (c) What is your attitude towards risk? (d) Compute the certainty equivalent, CE , of the gamble, which is the guaranteed amount of consumption that an individual would view as equally desirable as a risky gamble, that is EU gamble ( c ) = U ( CE ). (e) Suppose now that the coefficient of relative risk aversion is γ = 2 . Answer to the questions (a)-(d) above for with γ = 2 . Are agents more or less tolerant to risk than before? 2. (Arrow-Debreu Economy) Consider a world in which there are only two dates: 0 and 1. At date 1 there are three possible states of nature: a bad weather state (BW) and a good
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