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Question 2

Suppose that Jake considers two alternative investment plans of $1,000 for one-year. Investment A is a no-risk plan: deposit into a bank account with interest rates with 5%. That is, it makes $1,050 in a year for sure. Investment B is a risky plan: buying stocks. This plan could make $1,500 in a year if the economy is good, but if the economy is bad in a year, it could make only $600. According to recent forecases by economists, the probability that the economy is good in a year is 1/2.

1. Find the expected income and standard deviation of Investment B. (3 points)

  1. Suppose Jake’s utility function is âˆšI, where is the income. Find the expected utility from each investment. (3 points)

  2. Which investment would Jake choose? Why?(2 points)

  3. Is Jake risk-loving? Explain why shortly. (2 points)

  4. (Bonus Questions) How much of certain income would he give up to avoid risk? (Hint: What is a certain income that yields the same utility as an uncertain income yields?) (4 points)


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