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Problem: Ms A and Mr L have vNM utility functions v(y) =y1/2 and v(y) = y3/2, respectively. Each of them has an income of y = 1000 initially.
Required:
(a) Each of them is now oered a fair bet (π; z) = (1/7; 600;-100), i.e., with probability π = 1/ 7 the bettor wins and gets $600, and with probability 1 - π = 6/7 the bettor loses and has to pay $100. Represent this bet as a prospect. Who will take the bet and who will not?
(b) For the person who declines to take the bet, how much is he or she willing to pay to avoid the bet? How much must the other person be paid to give up the bet?
(c) Calculate the approximate risk premium for Ms. A and Mr. L, based on the Arrow-Pratt coecient of absolute risk aversion and compare them with what you found in the part (b).
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