is 11.5%. When bi = 0.75, then kc =+ - 7 1 5 10 7 11 5 . .% ( ) = kk k k c rf m rf =+ - i
b ( ) b k k k i c = - m rf Firm Behavior and Risk Aversion 647 b. When krf = 8 and
bi = 1.5, then GAME THEORY
(14.12) where CFt* is the risk-free cash flow and CFt is the actual, risky cash flow
that is considered to be equivalent to CFt*. Since CFt* CFt, then 0 at 1. When
CFt* = CFt, then at = 1, in which ca
maximum value of U*. Our discussion of the selection of an optimal portfolio was
very simple. It was restricted to the choice of the optimal combination of a single
risk-free and a single risky asset.
free U.S. Treasury bonds and risky Lugburz shares? Solution. From Equation (14.9),
the capital market line is The problem confronting Webb Ungoliant is to create a
portfolio of U.S. Treasury bonds and
laissez-faire, or nonintervention by government in the marketplace. The
conditions that define perfectly competitive market structures, however, are
rarely satisfied in practice. The output of differe
prices exhibiting more than the average price fluctuationshave beta coefficients
greater than unity (bi > 1), while stock prices that are less volatile have positive
beta coefficients less than unity
discussion of the snake oil salesman, who traveled from frontier town to frontier
town in the American West selling bottles of elixirs promising everything from a
cure for toothaches to a remedy for b
be assumed to be equally likely. This assumption effectively transforms the
problem of decision making under uncertainty into decision making under risk.
Consider again the situation depicted in Figur
Risk loving Preferring the expected value of a payoff to its certainty equivalent.
Risk neutrality Indifference between a certain payoff and its expected value.
Savage decision criterion A decision-ma
that a1 = 0.9, a2 = 0.8, a3 = 0.7, a4 = 0.6, and a5 = 0.5. The risk-free discount rate
is assumed to be 10%. Using the certainty-equivalent approach, the risk-adjusted
net present value of this invest
dealer price will fall. This will further exacerbate matters, since it will create an
even greater incentive for plum owners to avoid the used-car market and sell
privately. In the end, only lemons wi
Treasury bills and (1 - q) = 0.3333, or 33.33% consists of Lugburz shares. An
alternative solution to this problem is the Lagrange multiplier method. The first
step in the Lagrange multiplier method i
where Di is the decision index, Mi is the maximum payoff from each strategy, mi is
the minimum payoff from each strategy, and a is the coefficient of optimism. The
optimal strategy using the Hurwicz d
management of two firms deciding whether to adopt a high-price or a low-price
strategy. This is a sequential-move game in that firm A must first decide whether
to charge a high price or a low price wi
95% probability that firm B will charge a high price and a 5% probability that it will
charge a low price. Similarly, firm A believes that a lowprice strategy will result in a
2% probability that firm
for firm A is to charge a low price, which will result in a profit of $250,000,
compared with a profit of $100,000 if it adopts a high-price strategy. Thus, the
final optimal strategy profile for this
individual is willing to sacrifice is given by the distance CE. Thus, the indifference
curve IH reflects the greater care that an individual takes to avoid a loss,
compared with individuals who are le
invest, and if Slumlady Sally does not invest, then it is in Slumlord Larrys best
interest not to invest. Thus, if Slumlord Larry and Slumlady Sally do not cooperate,
the strategy profile cfw_Dont inv
If the risk-free discount rate is 10%, then the net present value of this investment
project is Suppose, on the other hand, the investor perceives the project as risky
and uses a risk-adjusted discoun
when the market consists of a high proportion of high-risk individuals, which has
the effect of moving the average-market fair-odds line closer to the fair-odds
Market Uncertainty and Insurance 673 0
instance, opportunity costs are measured as the absolute difference between the
payoff for each strategy and the strategy that yields the highest payoff from each
state of nature. Once these opportuni
Slumlord Larry, on the other hand, will find a sharp increase in the demand for his
apartments because of the positive effect on the neighborhood from Slumlady
Sallys investment. The opposite result w
results of the flip of the coin, the individual will still have a cash endowment of
$1,000, since no amount was placed at risk. Market Uncertainty and Insurance
667 1 For a detailed discussion of indi
hope of a big payoff, which in Figure 14.18 occurs with economic expansion.
Under the other two phases of the business cycle, this firm will earn the lowest
possible payoff. Since managers are ultimat
should be appropriate to the circumstances and consistent with organizational
objectives and philosophy. LAPLACE DECISION CRITERION Before examining in
detail the Laplace decision criterion for select