IB235 Finance 1 Seminar 2, Autumn Term

_________________________
Problems Investment under Certainty
All of the problems on this sheet are examinable.
Attempt A2 and A3 in preparation for the seminar in Week 3.

Applications

A1. (a) Mrs Spendthrift currently earns £80,000, but wants to consume £150,000 now. Her
income next period will be £90,000. What is the maximum amount that she can
consume next period, if the riskless lending or borrowing rate is 10% per annum?

(b) Mr Miserly currently earns £50,000, but wishes to consume only £35,000 now.
Next period, he will earn £60,000. What is the maximum amount that he can consume
next period, if the riskless lending or borrowing rate is 10% per annum?

A2. Consider the diagram below. An individual currently earns and consumes £40,000 and
will earn and (in the absence of any alternative capital investment opportunity)
consume £22,000 next period.

Consumption (£’000s)
next period
C

F B

E
22
G D A Consumption (£’000s)
this period
40 60 75
Suppose that the opportunity arises to invest now in the capital project represented by
point B. By combining this investment with riskless lending or borrowing, the
individual can attain any point along the line ABC.

(a) Calculate the rate of riskless lending or borrowing.

(b) Calculate the NPV of the capital project.

(c) Assuming the investor decides to undertake the capital project, how much should
he consume now if he wishes to consume the same amount now and in one
period’s time?

1
IB235 Finance 1 Seminar 2, Autumn Term

A3. An individual is worth £60,000 today. He has no income next period. He can do three
things with this money: spend some of it now, save some of it for next period or invest
some of it in a capital project. If he invests in the capital project, but does not lend or
borrow any money today, then he will be at point B in the diagram below.

Consumption (£’000s)
next period
D
90
C
67.5
B
56.25

E A Consumption (£’000s)
O this period
20 30 60 80

(a) Calculate the rate of riskless lending or borrowing.

(b) How much does the individual invest today in the capital project?

(c) Calculate the NPV of the capital project.

Suppose in fact that the individual wants to consume £20,000 now and £67,500 next
period. This pattern of consumption is represented by point C in the above diagram.

(d) How does he divide up his wealth between consuming today, saving for next
period and investing in the capital project? What is the NPV of the project now?

2
IB235 Finance 1 Seminar 2, Autumn Term

_________________________
Problems Risk Aversion and Expected Utility
All of the problems on this sheet are examinable.
Attempt T1, T2 and A1 in preparation for the seminar in Week 3.

Theory

T1. An investor has utility of wealth function U(W) = - e-aW, where a is a positive constant.

(a) Obtain expressions for U´(W) and U´´(W) as functions of W.

(b) Draw the graph of U(W) for values of W ≥ 0. What does the shape of the graph imply
about the investor?

(c) The coefficient of absolute risk aversion (ARA) is defined as:

U ¢¢(W )
ARA º -
U ¢(W )

Obtain an expression for this investor’s ARA. How would you interpret the result?

W 1-g
T2. An investor has utility of wealth function U (W ) = , where γ is a positive constant.
1- g

(a) Obtain expressions for U´(W) and U´´(W) as functions of W.

(b) Draw the graph of U(W) for values of W ≥ 0. What does the shape of the graph imply
about the investor?

(c) The coefficient of relative risk aversion (RRA) is defined as:

U ¢¢(W )
RRA º - W ×
U ¢(W )

Obtain an expression for this investor’s RRA. How would you interpret the result?

3
IB235 Finance 1 Seminar 2, Autumn Term

Applications

A1. An individual with utility-of-wealth function U(W ) = W can exchange his current
wealth W0 = £100 for the following simple lottery:

1/4 75
1/2
105
1/4 115
Calculate each of the following for this individual, assuming that he takes the gamble:

(a) expected wealth E[W].

(b) expected utility of wealth E[U(W)].
(c) certainty equivalent CE.
(d) coefficient of absolute risk aversion ARA, evaluated at E[W].
(e) coefficient of relative risk aversion RRA evaluated at E[W].
(f) Markowitz risk premium πM.
(g) Pratt-Arrow risk premium π.

A2. An investor with current wealth W0 = 1,000 has the opportunity to participate in a
gamble with the following possible payoffs next period:

1/4 500
1/2
200
1/4 -200

(a) Suppose that the investor has utility-of-wealth function:

1-γ
W
U(W ) = , g >0
1- γ
Calculate:

(i) the expected utility of his final wealth.

(ii) his certainty equivalent wealth.

for g = 2.0, 1.5, 1.1, 1.01 and 1.001. What do you observe?

(b) Repeat the above calculations assuming the investor’s utility-of-wealth function
is U(W ) = lnW . What do you observe?