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Chapter 17

Chapter 17. Uncertainty. Figure 17.01a Probability Distribution. (a) Less Certain. Probability, %. 40. Probability. distribution. 30. 20. 10. 10%. 40%. 20%. 10%. 20%. 0. 1. 2. 3. 4. Days of rain per month. Figure 17.01b Probability Distribution. (b) More Certain.

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Chapter 17

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  1. Chapter 17 Uncertainty

  2. Figure 17.01a Probability Distribution (a) Less Certain Probability, % 40 Probability distribution 30 20 10 10% 40% 20% 10% 20% 0 1 2 3 4 Days of rain per month

  3. Figure 17.01b Probability Distribution (b) More Certain Probability, % 40 Probability distribution 30 20 10 30% 40% 30% 0 1 2 3 4 Days of rain per month

  4. Figure 17.02 Risk Aversion Utility, U U (Wealth) c U ($70) = 140 0.1 U ($10) + 0.9 U ($70) = 133 f d U ($40) = 120 0.5 U ($10) + 0.5 U ($70) = e U ($26) = 105 b a U ($10) = 70 0 10 26 40 64 70 Wealth, $ Risk premium

  5. Figure 17.03a Risk Neutrality and Risk Preference (a) Risk-Neutral Individual Utility, U U (Wealth) c U ($70) = 140 0.5 U ($10) + 0.5 U ($70) = b U ($40) = 105 a U ($10) = 70 0 10 40 70 Wealth, $

  6. Figure 17.03b Risk Neutrality and Risk Preference (b) Risk-Preferring Individual Utility, U U (Wealth) c U ($70) = 140 0.5 U ($10) + b e 0.5 U ($70) = 105 U ($40) = 82 d a U ($10) = 70 0 10 40 58 70 Wealth, $

  7. Application Gambling Utility, U U (Wealth) e d c b * d * b a W W W W W Wealth 1 2 3 4 5

  8. Table 17.01 Variance and Standard Deviation: Measures of Risk

  9. Figure 17.04 Investment Decision Tree with Risk Aversion (a) Risk-Neutral Owner High demand $200 80% Invest = EV $140 Low demand – $100 20% = EV $140 Do not invest $0 (b) Risk-Averse Owner High demand U ($200) = 40 80% Invest = EU 32 Low demand – ( U $100) = 0 20% EU = 35 Do not invest U ($0) = 35

  10. Figure 17.05 Investment Decision Tree with Uncertainty and Discounting Next year This year High demand R = $125 80% Invest = EV $110 EPV = $100 C = $25 Low demand R = $50 20% = ENVP $75 Do not invest $0

  11. Figure 17.06 Investment Decision Tree with Advertising High demand $100 80% Advertise EV = $60 – $50 Low demand – $100 20% Invest = EV $10 High demand $100 Do not 40% = EV $10 advertise = EV – $20 Low demand – Do not invest $100 60% $0

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