Consider two individuals, Dave and Eva. Both Dave and Eva have initial wealth 810, 000 and face a 40% chance of losing L = 450, 000. Dave has von Neumann-Morgenstern utility function up(x)= x and Eva has von Neumann-Morgenstern utility function uE (x) = VT. 1. What do you know about Dave's and Eva's risk preferences? 2. What is the most Dave would be willing to pay for complete insurance against the loss? 3. What is the most Eva would be willing to pay for complete insurance against the loss?
There are three main types of risk preferences:
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Risk-averse: These individuals tend to prefer options that offer lower potential rewards but are less risky. They are more likely to choose a guaranteed payout over a chance at a higher payout, even if the potential gain is greater.
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Risk-neutral: These individuals are indifferent between options that offer different levels of risk. They are willing to take on risks if the potential reward is high enough, but are also willing to forego potential gains if the risk is too great.
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Risk-seeking: These individuals tend to prefer options that offer higher potential rewards, even if they come with a higher level of risk. They are more willing to take on risk in order to have a chance at a larger payout.
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