The Hotel Arcata faces a risk that it will suffer a fire causing a $ 200...

The Hotel Arcata faces a risk that it will suffer a fire causing a $ 200 million dollar loss with a probability of 0.02. The owner of the firm, Jackie Johnson, has a utility function of the form U(W) = W ^½, where W is the owner’s wealth. The wealth is measured by the value of the hotel, which is $ 225 million dollars (i.e., W = 225).

A. What is Jackie Johnson’s expected loss?

B. What is Jackie Johnson’s expected utility?

C. What is Jackie Johnson’s risk premium?

Solutions

Expert Solution

A. The expected loss would be the amount of the loss multiplied by the expected probability.

Expected loss = 200 × 0.02 = 4

B. Expected wealth = total wealth - expected loss = 200 - 4 = 196

Expected utility = (196)^1/2 = 14

C. Risk premium = Risk free return - expected return = 200 - 196 = 4

Rahul Sunny answered 2 years ago

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