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Assignment 1

Instructions

Assignment 1
The following exercises are for each student to complete individually. Your responses must be typed. Be sure to use superscript and subscript functions where appropriate, e.g. x2, xt. If you wish to include diagrams, tables, or excerpts of spreadsheets, they must be embedded within your document. You may need to make adjustments to ensure everything is legible in your document.
DO NOT include a cover page.
DO ensure your responses are clear and complete.
DO be sure you show any supporting calculations and include any relevant information and/or sources you use in reaching your final answer.
DO be concise with your answers. Assignments longer than 4 pages will suffer a grade penalty. You do not need to lengthen your assignment to reach 4 pages! But assignments longer than 4 pages will be penalized because we have a finite amount of graders’ time in this course.KEEP IN MIND: In this course, a financial example pertains to the domain of finance. Examples include investment decisions, corporate financing decisions, hedging against risks, etc. Note that consumer purchasing decisions are not financial decisions for the purposes of this course.
This assignment is due at the time/date stated on the course outline, via quercus.
1.a) In the context of prospect theory, briefly state the four-fold pattern of risk attitudes. You do not need to explain how the four-fold pattern of risk arises. Simply state the four-fold pattern.
b) Describe how the four-fold pattern of risk attitudes helps to explain the fact that many people buy both insurance and lottery tickets. Be precise.
2. Consider a person who has the following preferences, where w=wealth:Utility = w0.5 if w≥0= -(|w|0.5) if w<0
a) Are this person’s risk preferences accurately described as risk averse, risk neutral, or risk seeking? Pick one and briefly explain.
b) Separate from their risk preferences, is this person loss averse? If so, explain why. If not, provide a specific adjustment that would make the utility function incorporate loss aversion.
3. a) In your own words, define each of the concepts risk and ambiguity in a way that demonstrates the distinction between them.
b) Provide a simple financial example that incorporates risk in monetary payoffs. Be very clear about which features qualify your example as demonstrative of risk as opposed to ambiguity.
c) Explain how ambiguity aversion could be related to the home bias.
4.Consider the utility function U(W) = W0.5 where W = wealth. (a) Perform the necessary calculations to demonstrate the order of preference of an investor with this utility function. Order them from most preferred to least preferred.Prospect 1: 50% chance of \$1000, 50% chance of \$2000 Prospect 2: 25% chance of \$500, 25% chance of \$2000, 50% chance of \$1000Prospect 3: \$1000 for certain.
(b) Explain the meaning of the expression certainty equivalent. (That is, provide the definition.)
(c) Calculate the certainty equivalent of prospect 1.
5. Provide an example where an anchor might be used by a financial planner to influence her client’s financial decision in a way that is helpful to the client. Clearly define the anchor in your example and explain how the anchor is used in a way that is helpful to the client.
6. Provide a financial example where someone who works in the finance profession may make a decision influenced by heuristics in a way that makes them worse off than if they had made the decision free from the influence of heuristics. Explain fully to ensure the financial context is very clear and to clarify the way the example demonstrates the influence of a specific type of heuristic. (Your example must be different from any mentioned elsewhere in these assignment questions and must not rely on anchoring.)