term 2 - lecture 11 - uncertainty???

Question 1

what do individuals maximise?

Answer 1

the expected utility of optimal consumption that could afford in different scenarios

Question 2

what is the formal definition of a risk averse individual?

Answer 2

if the expected utility from the gamble is less than the utility of the expected prize

Question 3

what is the formal definition of a risk loving individual

Answer 3

if the expected utility from the gamble is greater than the utility of the expected prize

Question 4

what is the formal definition of a risk neutral individual?

Answer 4

if the expected utility from the gamble is equal to the utility of the expected prize

Question 5

what is the two usual measures of risk aversion?

Answer 5

arrow pratt measure of absolute risk aversion and the arrow pratt measure of relative risk aversion

Question 6

what is the formula for the arrow pratt measure of absolute risk aversion?

Answer 6

• u’‘(c)/u’(c)

Question 7

what is the formula for the arrow pratt measure of relative risk aversion?

Answer 7

-[u’‘(c)/u’(c)] *c

Question 8

how can we measure the exact degree of risk aversion by the utility function?

Answer 8

through considering how much concave the utility function is, the more concave the greater the degree of risk aversion

Question 9

what is a CARA utility function?

Answer 9

constant absolute risk aversion means the degree of risk aversion does not change with income such as the function u =1/r (1-e^-(rc))

Question 10

what is a CRRA utility function?

Answer 10

constant relative risk aversion.

Question 11

what is the consumers certainty equivalent income?

Answer 11

the perfectly safe income that would make him exactly as well off as if he participated in gambling

Question 12

if the consumer is risk neutral, what is the certainty equivalent compared to expected payoff?

Answer 12

the certainty equivalent is equal to the expected payoff

Question 13

if the consumer is risk averse, what is the certainty equivalent compared to expected payoff?

Answer 13

the certainty equivalent is lower than the expected payoff

Question 14

if the consumer is risk loving, what is the certainty equivalent compared to the expected payoff?

Answer 14

the certainty equivalent is greater than the expected payoff

Question 15

what is the risk premium?

Answer 15

the amount of additional reutrn that an agent requires to choose a gamble over a safe investment
risk premium = expected payoff - certainty equivalent

Question 16

what are the two main factors which affect the size of the risk premium?

Answer 16

a greater risk aversion is associated with a higher risk premium
a higher level of uncertainty is associated with a higher risk premium

Question 17

complete at a later day