Solutions to Practice Questions

Daniel Gottlieb

BEPP 305/805 - Fall, 2014

Instructions:

Use these questions along with the class slides, lecture notes, and problem sets as a
study guide to the midterm exam. I will post the solutions in a separate file.
Most of the material needed to answer these questions will not have been covered by the
time I post them online. Im posting them before we cover the full material to answer the
recurrent question: What kind of questions will you ask in the exam? Dont panic if you
run into a question that seems to require concepts that have not yet been covered. They
will be covered soon.

Question 1. Ann has an income of W = 90, 000. She faces theprisk of suering a loss of
L = 50, 000 with probability 10%. Ann has utility function u (W ) = W .
p p
@2
a) What is Anns coecient of absolute risk aversion? [Hint: @W
@
W = 2p1W and @W 2 W =
4W
1p
W
].
Her coecient of absolute risk aversion is
1
u00 (W ) p
4W W 1
= p = .
u0 (W ) 2 W 2W

b) What is Anns coecient of relative risk aversion?

Her coecient of relative risk aversion is
1p
u00 (W )W 4W
W 1
= pW = .
u0 (W ) 2 W 2

c) Suppose an insurance company oers an insurance policy that fully reimburses Ann in case of
loss. The policy costs $5, 000. Should Ann buy it? Justify.
Yes. Ann is risk averse since the utility function is concave: u00 (W ) = 4W 1pW < 0. Because this
policy is actuarially fair, Ann would like to fully insure.
There are two equally valid ways to justify why she would like to fully insure. The first one is to
mention that we defined a risk averse person as someone who prefers a certain wealth for sure
than an uncertain wealth with the same expected value. If she buys full insurance, Ann gets wealth
90, 000 5, 000 = 85, 000 for sure. If she does not buy insurance, she gets wealth 90, 000 with
probability 90% and 40, 000 with probability 10%. The expected wealth is 90, 000 90% + 40, 000
10% = 85, 000, which is the same as before.
The second justification is to mention the Mossins theorem, which shows that risk averse people
should fully insure when facing actuarially fair insurance policies.

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d) Now suppose the same insurance policy as in (c) costs $27, 500. Should Ann buy it? Justify.

No. If she buys it, her utility is

p p
90, 000 27, 500 = 62, 500 = 250.
If she doesnt buy, her utility is
9p 1p 9 300 200
90, 000 + 40, 000 = + = 290.
10 10 10 10

Ann has a twin sister, Barbara, with the same income W = 90, 000 and who also faces a 10%
risk of suering the $50, 000 loss. Both risks are independent. For the remainder of the section
suppose they do not buy any insurance.
e) Suppose Ann and Barbara decide to split the total losses. What is Ann and Barbaras (per-
person) utility if they split the total loss?
2
If they split the total losses, they face zero loss with probability 10
9
, two losses with probability
1 2
10
, and one loss with probability 2 10 10 . The per-person utility is then:
9 1

2 2
9 p 9 1p 1 p
90, 000 + 2 65, 000 + 40, 000
10 10 10 10
2 2
9 9 1p 1
= 300 + 2 65, 000 + 200 290.9
10 10 10 10

f) Would Ann and Barbara prefer to split their losses or would they prefer not to split them?
Justify.
If they split the losses, they get expected utility 290.9. If they do not, they get expected utility 290
(from part d). Therefore, they prefer to split the losses.
g) Show that their per-capita incomes if they decide to split the total losses second order stochas-
tically dominates their per-capita incomes if they do not split the losses. Interpret.
There are two dierent ways to solve this question. Recall that second order stochastic dom-
inance is equivalent to (I) mean-preserving spread, or (II) having the same mean and everyone
with a concave utility function preferring one gamble to the other. Therefore, you can show either
one of them.

2
 Mean preserving spread argument:
If they split the losses, they each get a (per-capita) income distributed according to
2 2 !
9 1 9 1
90, 000, ; 65, 000, 2 ; 40, 000, .
10 10 10 10

If they do not split, they get (90, 000, 10

9 1
; 40, 000, 10 ). As the picture below shows, we can write
the gamble if they dont share the risk as the sum between the gamble when they share plus a noise
term with mean zero. This is equal to zero in the high and low nodes (90, 000 and 40, 000) and
is equal to +25, 000 with 50% chance and 25, 000 with 50% chance in the middle node (65, 000).

Concave utility function argument:

We need to verify that, for any concave u, the following inequality is true
2 2
9 9 1 1 9 1
u (90, 000) + 2 u (65, 000) + u (40, 000) u (90, 000) + u (40, 000) .
10 10 10 10 10 10

Rearranging:
" 2 # " 2 #
9 9 9 1 1 1
u (90, 000) + 2 u (65, 000) u (40, 000)
10 10 10 10 10 10

9 1 9 1 1 9
) u (90, 000) + 2 u (65, 000) u (40, 000)
10 10 10 10 10 10
u (90, 000) + u (40, 000)
) u (65, 000) .
2
The term on the left is the utility of 65, 000, which is the midpoint between 90, 000 and 40, 000.
The term on the right is the expected utility of getting 90, 000 with probability 12 and 40, 000 with
probability 12 . As weve seen in class, whenever u is concave, the utility of the expected value is
always greater than the expected utility (see Lecture 4; slides 19-24).

3
h) If Ann and Barbara decide to split the losses, do their per-capita incomes first order stochas-
tically dominate their per-capita incomes if they do not split the losses? Justify
No. There are two possible ways to solve this question. Recall that first order stochastic
dominance is equivalent to: (I) everyone with an increasing utility function prefers one gamble to
the other; (II) the cdf of one gamble being always smaller than the other. You can verify any of
them.
If you decide to calculate the cdfs, you will get
8
>
> 0 if x < 40, 000
< 1 2
if 40, 000 x < 65, 000
FSplit (x) = 10 .
>
> 2 1 9
if 65, 000 x < 90, 000
: 10 10
1 if x 90, 000
8
< 0 if x < 40, 000
FN o Split (x) = 1
if 40, 000 x < 90, 000 .
: 10
1 if x 90, 000
Note that, for x 2 [40, 000; 65, 000), we have FSplit (x) = 0.01 < 0.1 = FN o Split (x) and, for
x 2 [65, 000; 90, 000), we have FSplit (x) = .181 > 0.1 = FN o Split (x).
You could also substitute any increasing convex function and see that you will prefer not to
split the losses (since you are risk-seeking). For example, if you take u(x) = x2 , the expected
utility of spliting the losses is
2 2
9 2 9 1 2 1
(90, 000) + 2 (65, 000) + (40, 000)2 = 7, 337, 500, 000.
10 10 10 10
The expected utility of not splitting the losses is
9 1
(90, 000)2 + (40, 000)2 = 7, 450, 000, 000 > 7, 337, 500, 000.
10 10
Since x2 is an increasing function when x > 0 this contradicts the claim that everyone with an
increasing utility function will prefer to split the losses.

Question 2. John has utility function u (X) = X 2 and has the risk of suering a loss L. An
insurance company oers full insurance at actuarially fair prices. Should John buy the insurance?
@2
Justify. [Hint: @X
@
(X 2 ) = 2X and @X 2
2 (X ) = 2].

No. John is risk seeking (since u is convex for X > 0) so he prefers an uncertain wealth
amount to a certain wealth with the same expected value.
Question 3. Michael has utility function u(X) = ln (X). He has the option of allocating his
wealth between a riskless and a risky asset.
a) Is the optimal amount of dollars invested in the risky asset an increasing, decreasing or constant
@2
function of Johns wealth? Justify. [Hint: @X@
(ln X) = X1 and @X 2 (ln X) =
1
X2
]
He has decreasing absolute risk aversion ( X1 ). Thus, it should be an increasing function of his
wealth.

4
b) Is the proportion of his wealth allocated to risky assets an increasing, decreasing, or constant
function of his wealth? Justify.
He has constant relative risk aversion (1). Thus, it should be a constant function of his wealth.
Question 4. William has initial liquid wealth of $5, 000 and a car that has value $3, 000. There is
a probability 10% of an accident that destroys the car completely. Williams has Bernoulli utility
function u(W ) = ln(W ), where W is his total wealth (car value plus liquid wealth).
a) An insurance company sells as many insurance policies as customers want but charges a positive
load of l = 10%. Should William fully insure? Justify.
No. By Mossins Theorem, he should partially insure because the policy has a positive load.
(Alternatively, you could calculate the expected utility of these policies and you would obtain the
exact same result; both ways are correct).

b) Another insurance company oers only a full insurance policy but charges actuarially fair
prices. If William can choose to buy from either this insurance company or the one from part
(a), which one should he pick?
He should pick this one. Mossins theorem tells us that the best he can do when he can pick
the coverage is to choose full insurance when he has access to actuarially fair policies. Thus, the
policy oered here (full insurance) is better than the one in (a).
(Alternatively, you could calculate the expected utility of these policies and you would obtain
the exact same result; both ways are correct).

Question 5. Deborah has Bernoulli utility function u(W ) = exp( W ). [Hint: @

@X
(exp( X)) =
exp( X)].
a) What is Deborahs coecient of absolute risk aversion?
u00 (W )
u0 (W )
= 1.

b) What is Deborahs coecient of relative risk aversion?

u00 (W )W
u0 (W )
= W.

For parts (c) and (d), suppose that Deborah has the option of allocating her wealth between a
riskless and a risky asset.

5
c) Would the optimal amount of risky assets (in dollars) be an increasing or decreasing function
of her wealth? Justify.
Constant. This utility has constant absolute risk aversion.
d) Would the optimal proportion of her wealth allocated to risky assets be an increasing or
decreasing function of her wealth? Justify.
Decreasing. There are two equivalent ways to justify this answer. One of them is to use the
fact that it has increasing relative risk aversion (from b). The other way to justify the answer is
to use the fact that the optimal amount of risky assets (in dollars) is constant. Therefore, the
proportion allocated to risky assets has to be decreasing in W .
For parts (e) and (f), suppose Deborah faces the risk of a loss of L dollars with probability p > 0.
e) An insurance company oers as much coverage as she desires at an actuarially fair price. Would
Deborah prefer to fully insure? Justify.
Yes. She is risk averse so, by Mossins theorem, she should fully insure.
f) Now suppose the insurance company oers insurance at a positive load l > 0. Deborah can still
purchase any coverage she wants but the price of each unit of coverage is p + l. Would Deborah
prefer to fully insure? Justify.
No. Again, Mossins theorem tells us that she should partially insure when policies have positive
loads.
g) Would the policies picked in (e) and (f) be an increasing, constant, or decreasing function of
Deborahs wealth? Justify.
Constant. Because this utility function has constant absolute risk aversion.
If you want to show this result formally, you need to write down Deborahs expected utility:

p [ exp (W (p + l) I L + I)] + (1 p) [ exp (W (p + l) I)] .

Taking the derivative and setting equal to zero, we obtain:

p (1 p l) [ exp (W (p + l) I L + I)] = (1 p) (p + l) [ exp (W (p + l) I)] .

As in problem set 3, we can separate out the W from the exponential term:

p (1 p l) [ exp ( (p + l) I L + I)] exp (W ) = (1 p) (p + l) [ exp ( (p + l) I)] exp (W ) .

Therefore, W cancels out in the expression for the optimal insurance level I:

p (1 p l) [ exp ( (p + l) I L + I)] = (1 p) (p + l) [ exp ( (p + l) I)] .

This means that the optimal amount of insurance is the same for all wealth levels. If you want,
you can also explicitly calculate the expression for I by taking logs of both sides (following similar
steps as in Problem Set 3) but this isnt necessary to answer the question.

Question 6. Briefly describe three weaknesses of the mean-variance criterion discussed in class.
It violates FOSD (or negative marginal utility), it generates increasing absolute risk aversion
(unreasonable because it implies that people should buy less risky assets as they become wealthier),
and generates no precautionary savings.

6
Question 7. Aline is considering leaving her current job and start her own business. Her current
job pays $10, 000 (per month) with certainty. In her new business, she expects to earn $22, 500,
$10, 000, or $0 (per month) with probability 13 each.
a) If Aline is risk neutral, should she leave her current job and start the new business?
Yes. If she is risk neutral, she should choose the option that maximizes expected value, and
starting the new business has a higher expected payment:
1 32, 500
(22, 500 + 10, 000 + 0) = > 10, 000.
3 3

p
For parts (b) and (c), assume that Alines utility function is u(W ) = W , where W is her
monthly income.
b) Is Aline risk loving, risk neutral, or risk averse? Justify.
She is risk averse because her Bernoulli utility is concave.
c) Should she leave her current job and start the new business? Justify.
The expected utility of starting the new business is
1 p p p 1
22, 500 + 10, 000 + 0 = (150 + 100 + 0) 83.33.
3 3
p
The expected utility of staying at her current job is 10, 000 = 100. Therefore, she should stay at
the current job.

d) Can the new business and the current job be ranked in terms of first order stochastic domi-
nance? Justify.
No. Recall that first order stochastic dominance means that anyone with a strictly increasing
utility function should prefer one gamble to the other. In this case, weve seen that she prefers the
new business if she has linear utility function (i.e., she is risk neutral) in part a, but she prefers
to stay at her old job if she has a square root utility (part b). Because both utility functions are
increasing, we cant rank them in terms of first order stochastic dominance.
(Alternatively, you could have solved this question by comparing the cummulative distributions or
the VaRs at all levels).
e) Calculate the VaR of the current job and the new business at 10% level.
The VaR at her current job is 10,000 at all levels. The VaR at the new business at 10% level is
0.
f) Calculate the expected shortfall of the current job and the new business at 15% level.
The expected shortfall at the current job is 10, 000 at all levels. The expected shortfall at the
new business at 15% is 0.

7
g) Suppose the government is considering implementing a progressive income tax that would
change the payout of the new business to either $20, 000, $10, 000, or $0 with probabilities 13
each. Would the current job second order stochastically dominate the new business if the tax is
implemented? Justify.
Yes. There are 2 ways to answer this question: you could express the distributions in terms of
mean preserving spreads or argue that anyone with a concave utility should prefer one to the other.
After this new income tax, the wealth in the new business has the same mean as the current job,
but has a random payout. Since people with concave utilities would always prefer a certain wealth
level to a random wealth with the same mean, it follows that anyone with a concave utility would
prefer the current job.
If you prefer to work with mean preserving spreads, you should note that the payment of the
new business is equal to the one from the old business 10, 000 plus the gamble (+10, 000, 13 ; 0, 13 ;
10, 000, 31 ), which has zero mean.

h) Suppose Aline chooses according to a mean-variance criterion:

E [W ] bV ar(W ),

where b is a positive number. For which values of b would she choose to start her new business?
Justify.
The variance of the new business is 84,722,222. She would prefer to start the new business if
32, 500
84, 722, 222 b > 10, 000.
3
Rearranging, we obtain:
2, 500 2, 500
>b)b<
3 84, 722, 222 3 84, 722, 222

8
Question 8. Peter expects to live for two periods: this decade and next decade. His total income
this decadepis I1 = 100 and his income next decade is I2 = 0 (he will retire). His utility function
is u(X) = X.
a) Suppose his discount rate is r = 50% (per decade) and the market interest rate is 50% (per
decade). What is is total consumption in each decade, C1 and C2 ?
In this case, C1 = C2 (because i = r). Therefore, we must have:

C 0 2.5
C+ = 100 + )C = 100 ) C = 60.
1.5 1.5 1.5

b) Suppose his discount rate is smaller than the market interest rate. Should his consumption
this decade C1 be greater than, equal to, or smaller than his consumption in the next decade C2 ?
Justify.

C1 < C2 since he is more patient than the market. As weve seen in class, people with a lower
discount rate than the market interest rate should have in increasing consumption profile.
c) Unfortunately, Peters bank would not lend money to him and, therefore, he cannot borrow.
He can still save as much as he wants. How do your answers to (a) and (b) above change under
these new conditions? Justify.

The answers dont change since Peters optimal inter-temporal consumption requires him to
save (rather than borrow) in both cases.