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?