Question

Suppose a bank has $100 million of assets to invest in either risky or safe investments. The first option is to put all assets in the safe investment, which will result in a 5% return and yield $105 one year from now. A second option is to put all the assets in the risky option, which will result in either a 50% return ($150 million) or a 40% loss ($60 million) with equal probability.


If the bank can pay to insure itself against losses, what is the maximum it would be willing to pay under the risky option?

Answer 1

(ANSWER.)

In safe investment yield will be $105.

in risky investment expected yield will

                                                  

Beacause both the returns have same probablity.

By insuring the risk bank can make sure to earn $150. Therefore by giving any amount higher than $45million to insure risk will lower the expected return from risky investment lower than from the safe investment. The bank's maximum willimgness to pay (WP) for insurance will be difference between the return with insurance and return without insurance

                                            WP=$150-$105=$45