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(w)
u
(w)
,
where u is the utility of w. R
r
(w) is called the measure of relative risk aver-
sion. Suppose there are i = 1, . . . , n future states of the world, each of which
will occur with probability p
i
. The rate of return of the risky asset in each
state of the world is r
i
> 1. Let 0 denote the amount of wealth to
be put in the risky asset. There is also a safe asset yielding a rate of return
s > 1 for sure. Moreover, it holds that r
i
< s in at least one state of the
world.
a) Show that an expected utility maximizing investor determines by
solving
max
i=1
p
i
u(w(1 + s) + (r
i
s)), 0 w. (1)
b) Suppose the investor is risk-averse. Show that the expected utility
maximizing investor chooses
i=1
p
i
r
i
> s.
Interpret this nding.
c) Suppose that
(c
t
) = . Hence, lifetime utility
of the consumer may be written as
T
t=0
t
u(c(t)),
where (0, 1) represents the discount factor.
The choice of the consumer is over {c
t
, S
t+1
}
T
t=0
and the utility maximiza-
tion problem may be stated as follows:
max
{c
t
,S
t+1
}
T
t=0
T
t=0
t
u(c
t
)
s.t. c
t
+ S
t+1
=S
t
,
c
t
, S
t
0 t,
S
0
>0 given.
a) Argue the problem may be written as
max
{c
t
,S
t+1
}
T
t=0
T
t=0
t
u(c
t
)
s.t. c
t
+ S
t+1
=S
t
,
S
T+1
0,
S
0
>0 given.
b) Find the Kuhn-Tucker optimality conditions to the problem in a) and
interpret them.
3