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Uncertainty

Bob Builder is considering some investments. He has $100,000 to invest in either real estate or

t-bills. T-bills will pay Bob a guaranteed three percent return over one year. Bob’s potential real estate investment has a return based on market conditions that have some risk involved. (Assume no taxes and that we are only considering a one year investment)

Type of market

% Gain or loss from market condition over one year

% Chance of market condition

Hot Market

50

25

Steady Market

0

50

Poor Market

-35

25

(a) Assuming Bob is risk neutral, show what investment Bob will pick and why. (5)

(b) Is your answer any different if Bob’s utility function was represented by the following utility function over wealth? U = 5W0.5, where W = wealth at the end of one year. Show why or why not. (5)

(c) What is Bob’s risk premium of the real estate investment? (5)

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Uncertainty
Bob Builder is considering some investments. He has $100,000 to invest in either real estate or tbills. T-bills will pay Bob a guaranteed three percent return over one year. Bob’s...

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