# ce - Investment Analysis The Certainty Equivalence Method...

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Investment Analysis The Certainty Equivalence Method

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Certainty Equivalence A game of chance: Flip a coin Heads: you win \$1,000,000 Tails: you win nothing Expected value = the probability weighted average value of all possible outcomes. Expected value = \$500,000
Certainty Equivalence A game of chance: Flip a coin Heads: you win \$1,000,000 Tails: you win nothing The house offers to buy you out of the game for \$10,000 right now. Do you take the money or do you flip? Deal or no deal?

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Certainty Equivalence A game of chance: Flip a coin Heads: you win \$1,000,000 Tails: you win nothing What if the offer is \$400,000? Deal or no deal?
The price you take to give up your chance to flip the coin is called the “certainty equivalence” (CE). You are willing to give up an uncertain outcome for a certain outcome. Psychology studies have shown that the

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## This note was uploaded on 02/09/2012 for the course MGT 3078 taught by Professor Marchman during the Spring '12 term at Georgia Tech.

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ce - Investment Analysis The Certainty Equivalence Method...

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