1. Suppose your utility function can be characterized by U(W) = lnW, and you are facing a gamble in which you stand either to win or to lose $2000. Each outcome has a probability of .5. How much would you be willing to pay to avoid this gamble if your initial wealth were $5000? How much would you be willing to pay if your initial wealth were $1,000,000? How would your answer dier if your utility function were characterized instead by U(W) = 1/W? 2. A store-owner faces a probability of .02 that a hurricane will reduce the value of his store to $1 during the next year. There is also a probability of .03 that a hurricane will reduce the stores value to $500,000, and a probability of .95 that no hurricane will occur, in which case the store is worth $1,000,000. An insurance company is willing to insure the store at its current market value. That is, if a hurricane occurs, the insurance company will pay the dierence between $1 million and the stores value after the storm. If the store-owners utility function is U(W) = lnW, what is the maximum amount he will be willing to pay to buy this insurance? 3. Many people purchase lottery tickets. This purchase represents an exchange of a sure amount of wealth (the cost of the ticket) for an uncertain amount (that is, a payo of either zero or the lottery jackpot. Moreover, the expected payo on the lottery ticket is less than the cost of the ticket. Many of the same people purchase property insurance. This purchase represents an exchange of an uncertain amount of wealth (the value of the property uninsured) for a certain amount (the insured value of the property). Does this purchase represent rational behavior? If so, how can it be explained? 4. You are interested in buying a store with a value of $1,000,000. You have $1,500,000 and you decide to place the rest in a bank deposit with an interest rate of 10% per year for 6 months. There is a probability of .001 that your store will burn to the ground and its value will be reduced to zero. With a power utility (U(W) = 1/W) of the wealth 6 months in the future, how much would you be willing to pay for insurance (at the beginning)? Assume that if the house does not burn down, its end-of-year value still will be $1,000,000. Conf. dr. Radu Lupu Asist. dr. Sorin Dumitrescu, CFA 1