Risk Math Example 4

Follow the full solution, then compare it with the other examples linked below.

Example 4

hard
Two investment options: A = certain gain of \500;B=60500; B = 60% chance of \1000, 40% chance of \$0. Calculate EV for both. Which would a risk-neutral person choose? A risk-averse person?

Solution

  1. 1
    EV(A) = \$500 (certain)
  2. 2
    EV(B) = 0.60 \times 1000 + 0.40 \times 0 = \600$
  3. 3
    Risk-neutral: chooses B (higher EV = \600 > \500)
  4. 4
    Risk-averse: may choose A β€” certainty of \500 is worth more than uncertain \600; psychological cost of potential \$0 outcome matters

Answer

EV: A=\500, B=\600. Risk-neutral chooses B; risk-averse might prefer A's certainty.
Risk tolerance determines decision-making when EV isn't equal. Risk-neutral agents maximize EV; risk-averse agents value certainty and pay a 'risk premium' to avoid uncertainty. Both approaches are rational depending on an individual's utility function.

About Risk

Risk is the possibility of loss or negative outcome, quantified by combining the probability of the event with the severity of its impact: Expected Loss = P(loss) times amount of loss.

Learn more about Risk β†’

More Risk Examples

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Example 2 hard

Should you buy insurance for [formula]5000 loss occurring with probability 0.03? Calculate expected

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