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Exercise on Expected Utility and Financial Markets, Assignments of Microeconomics

Three economics exercises from 'micro principles' by j. Wahl, focusing on expected utility theory and financial markets. The exercises involve making decisions under risk, determining indifference points on utility curves, and calculating minimum required returns for investments in different currencies.

Typology: Assignments

Pre 2010

Uploaded on 11/30/2009

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EXERCISE 12: Expected Utility and Financial Markets
J. Wahl – Micro Principles
1. Suppose you are appearing on "Let's Make A Deal." Monte Hall approaches you and
offers you a check for $1 million or the chance to pick a slip of paper out of a hat. The hat
contains 100 slips of paper: 89 of them entitle you to a package worth $1 million (a Chrysler
Cordoba, a cruise in the Caribbean, and a lovely new dining room set), 1 slip gives you nothing,
and 10 slips entitle you to a package worth $5 million (a trip around the world, a house in Palm
Springs, and a winter vacation in the Greek Isles).
Would you take the check or choose to pick a slip out of the hat?
What does your choice tell you about your attitudes toward risk?
2. Now suppose you face a simple, 2-choice gamble: $1 million 90% of the time, and $5
million 10% of the time. Suppose you are just indifferent to taking the gamble or
receiving a check for $1.1 million. What does your U(Y) curve look like? What is the
relationship between risk preferences and the U(Y) curve?
3 Suppose you could earn 10 percent annually on a dollar-denominated asset. Currently, the
exchange rate of dollars for yen is 100. Suppose you expect the dollar to depreciate against the yen;
in fact, you predict that the exchange rate will fall to 96 at the end of one year. What is the
minimum rate you would have to earn on a yen-denominated asset to make you willing to hold it?

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EXERCISE 12: Expected Utility and Financial Markets J. Wahl – Micro Principles

  1. Suppose you are appearing on "Let's Make A Deal." Monte Hall approaches you and offers you a check for $1 million or the chance to pick a slip of paper out of a hat. The hat contains 100 slips of paper: 89 of them entitle you to a package worth $1 million (a Chrysler Cordoba, a cruise in the Caribbean, and a lovely new dining room set), 1 slip gives you nothing, and 10 slips entitle you to a package worth $5 million (a trip around the world, a house in Palm Springs, and a winter vacation in the Greek Isles). Would you take the check or choose to pick a slip out of the hat? What does your choice tell you about your attitudes toward risk?
  2. Now suppose you face a simple, 2-choice gamble: $1 million 90% of the time, and $ million 10% of the time. Suppose you are just indifferent to taking the gamble or receiving a check for $1.1 million. What does your U(Y) curve look like? What is the relationship between risk preferences and the U(Y) curve? 3 Suppose you could earn 10 percent annually on a dollar-denominated asset. Currently, the exchange rate of dollars for yen is 100. Suppose you expect the dollar to depreciate against the yen; in fact, you predict that the exchange rate will fall to 96 at the end of one year. What is the minimum rate you would have to earn on a yen-denominated asset to make you willing to hold it?