Department of Statistics, The Chinese University of Hong Kong

RMSC 2001 Introduction to Risk Management (Term 2, 2023-24)

Solution to Assignment 2

1. Which of the following utility functions are valid for modelling the preference of a risk-averse investor for
√
w ≥ 0? (a) U (w) = w2 ; (b) U (w) = w−2 and (c) U (w) = w.

Solution:
We check their derivatives:

(a) As U ′ (w) = 2w and U ′′ (w) = 2 > 0, we know that the investor is risk seeking.
(b) As U ′ (w) = −2w−3 < 0, it is not a valid utility function.
(c) As U ′ (w) = 12 w−1/2 and U ′′ (w) = − 14 w−3/2 < 0, we know that the investor is risk averse.

2. A person with utility function U (w) = 1 − e−0.05w , where w ≥ 0 is offered $20 against the gamble $30
with the probability (0.5 + p), $15 with the probability (0.5 − p). Find the smallest value of p at or above
which the game is an attractive one.

Solution:
To make the game an attractive one, we need a larger expected utility for the gamble, which gives us

(0.5 + p)(1 − e−0.05×30 ) + (0.5 − p)(1 − e−0.05×15 ) ≥ 1 − e−0.05×20 .

We get p ≥ −0.08.

3. Suppose that you are a ventured capitalist and you are considering two possible investment alternatives for
the coming year. The first alternative is to buy Treasury bills, which will give you a wealth of $ M for sure.
The second alternative has three possible outcomes. They will produce wealth levels $10, $5, and $1 with
√
corresponding probabilities 0.2, 0.4, and 0.4 respectively. Your utility function for money is U (x) = 2 x.

a. Evaluate the expected utility for these two choices.

b. Which choice would you prefer if M = 6?
c. Find the value of M so that the expected utility of these two choices are the same. How do you interpret
this result?
d. Find the second derivative of U . Is U concave or convex?
e. What can you say about your attitude toward risk for this U ?

Solution:

√
(a) The expected utility of the first choice is E(U (W )) = 2 M , and of the second is
√ √ √
E(U (W )) = 2 10 × 0.2 + 2 5 × 0.4 + 2 1 × 0.4 ≈ 3.8538.
√
(b) If M = 6, then 2 M = 4.8990 > 3.8538, so the first choice is more preferrable.

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 √
(c) Let 2 M = 3.8538, we get M = 3.71. So one will be indifferent to the two choices if M = 3.71.
Notice that M is the certainty of equivalence.
(d) U ′ (x) = x−1/2 and U ′′ (x) = − 12 x−3/2 < 0 for x > 0. Hence U (x) is concave.
(e) I am a risk-adverse person.

4. Assume an initial wealth of $100, 000 and a 5% probability of incurring a $10, 000 loss. Given a natural
logarithm utility function and the fact that the insurance company charges at 5.1% of the insured amount.
How much insurance will the individual buys so that he can maximize his expected utility?

Solution:
Suppose the individual buys an insurance of amount x, then the expected utilitywill be

E {U (W (x))} = 0.05 × log(100, 000 − 10, 000 + x − 0.051x) + 0.95 × log(100, 000 − 0.051x).

To find the maximum of {U (W (x))} as a function of x, we take the derivative with respect to it and set to
0, we get
0.05 × (1 − 0.051) 0.95 × (−0.051)
= .
90, 000 + (1 − 0.051)x 100, 000 + (−0.051)x
Hence, x = 7944.38.

5. Suppose you have to pay $2 to play a gamble. You earn $19 with probability 1/3 and nothing with probability
2/3. Your current wealth is $10 and your utility function is U (x) = log(x), x > 0. What is the certainty
equivalence of this gamble? What is risk premium? Should you play the gamble or not?
Solution:
By the definition of certainty equivalence, we can compute the expected utility of this gamble as

1 2
E[u(G)] = × log 27 + × log 8 = log 12
3 3
To find find the certainty equivalence C by solving the equality

u(C) = log C = E[u(G)] = log 12 =⇒ C = 12

Moreover the expected value of the gamble can be easily computed 31 × 27 + 23 × 8 = 3 ,

43
and the risk
premium is given by E(G) − C = 43 3 − 12 = 3 . Therefore, we should play the gamble.
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6. Suppose that Misato’s is an expected utility maximiser, with the utility function U (w) = log(w), for w > 0
(use natural log).

i. What is Misato’s certainty equivalent of the following lottery:

Probability Money
0.4 30
0.5 100
0.1 500

ii. What is the risk premium Misato is willing to pay to insure against this uncertain prospect?

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iii. Suppose that Misato has $1,200,000 in wealth, and decides to open a stationery shop called Penpen.
She finds a tract of land for sale for $1,000,000, which will produce no return at all if she cannot get
the business licence from the Toyko-3 council, or will yield $10,000,000 of income (net of operating
expenses but not of the cost of the land) if the stationer can be successfully opened. Let p ∈ [0, 1] be the
probability that she can get the business licence. Specify the two lotteries that result from the actions,
“open the stationer” and “not open the stationer”. What probability p of getting the approval would
make Misato exactly indifferent between opening the shop and not opening it?

Solution:

(a) The expected utility is

E(W ) = log(30) × 0.4 + log(100) × 0.5 + log(500) × 0.1 = 4.2845.

Hence, Misato’s CE can be found from log(CE) = 4.2845, so CE = 72.57.

(b) The expected return is E(W ) = 30 × 0.4 + 100 × 0.5 + 500 × 0.1 = 112. So the risk premiuum
is 112 − 72.57 = 39.43.
(c) Lottery 1 - Open the stationer: G1 := G1 (10200000, 200000 : p).
Lottery 2 - Not open the stationer: G2 := G2 (1200000 : 1).
The expected utilities are:

E(U (G1 )) = log(10, 200, 000) × p + log(200, 000) × (1 − p) = log(200, 000) + p log(51),

and
E(U (G2 )) = log(1, 200, 000).
If Misato is indifferent to the two options, then

log(200, 000) + p log(51) = log(1, 200, 000).

Solve for p = log(6)/ log(51) = 0.4557.