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

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