I have a few (hopefully) helpful hints to offer concerning the Chapter 13 Problem Set:

  1. On problem 2 (which corresponds to Problem 6, page 459 in the textbook), in order to determine whether the CEO is a risk averter, a risk lover, or risk neutral, the simplest way to document this is to compare her certainty-equivalent wealth (WCE) with her expected value of wealth (E(W)) under the scenarios that are described in the problem.  Specifically,
    • if WCE < E(W), then she is a risk averter (since this indicates that the value of the gamble is less than its expected value; thus she is only willing to bear risk if she is “paid” to do so);
    • if WCE = E(W), then she is risk neutral (since this indicates that the value of the gamble is equal to its expected value; thus she is indifferent about bearing risk); or,
    • if WCE > E(W), then she is a risk lover (since this indicates that the value of the gamble is greater than its expected value; thus she likes to bear risk and is willing to “pay” for the opportunity to do so).
  2. In problem 3, there are 7 states of the world associated with the 7 (equally probable) bonus outcomes, and the probability of each state is 1/7.  Since initial wealth is $0, this implies that state-contingent wealth ranges from a low of $80,000 (which corresponds to the state in which no bonus is paid) to a high of $140,000 (which corresponds to the state in which a $60,000 bonus is paid).
  3. In problem 4, the percentages listed correspond to probabilities; e.g., the way to interpret the “make contact” probability distribution listed as (out, 0.65; single, 0.35) is that when Ken selects the “make contact” batting strategy, he has a 65% probability of an out and a 35% probability of a single.  Similarly, the way to interpret the “swing for the fences” probability distribution listed as (out, 0.75; double, 0.15; homerun, 0.1) is that when Ken selects the “swing for the fences” batting strategy, he has a 75% probability of an out, a 15% probability of a double, and a 10% probability of a homerun.
  4. In problem 5, if this person purchases full insurance coverage, this implies that in exchange for an insurance premium paid prior to the accident, the insurer will pay the full amount of the loss if and when it occurs. Basically, he replaces an uncertain loss (i.e., the $300 loss that has a 20% chance of occurring) with a certain loss (i.e., the insurance premium).  Thus the cost of full insurance coverage is that it reduces wealth by the amount of the premium, but the benefit is that his wealth, net of the insurance premium, is no longer affected by the accident.
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