Question

As you know, utility functions incorporate a decision maker’s attitude towards risk. Let’s assume that the following utilities were assessed for Steven Smith.

x	u(x)
-$400	0
-$365	10
-$320	20
-$270	30
-$200	40
-$110	50
$0	60
$130	70
$300	80
$600	90
$800	95
$1,100	100

Use these utilities to answer the following questions.

a) What is the monetary certainty equivalent for the following gamble: gain $130 with probability 0.4, lose $320 with probability 0.6?

b) What is the risk premium in a)? Explain the concept of a risk premium in addition to calculating its value for a)

Answer 1