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Behavioural Finance Topic 11 – Revision Session16 May 2019 Lecture
June 2018 Exam
1)
(i)
• Value (appreciated): 900’000 x 1.4 = 1’260’000
• Less mortgage: (500’000)
• Wealth 760’000
• Less rebuild cost (610’000)
• Wealth if it burns 150’000
U (w2) > U (w1).
• U (w1) = 0.999 x U (760’000) + 0.001 x U (150’000) = 0.999 x 871.780 + 0.001 x 387.298 =
870.908 + 0.387 = 871.295.
• U (w2) (if they buy insurance) = (760’000 – premium)1/2 🡪 760’000 – p = 871.2952 = 759.155 🡪
p= $845.
(ii)
• Expected payout = 0.001 x $610’000 = $610
• Risk premium = $235.
• The risk premium represents the amount above the expected return that somebody is willing
to pay to get rid of the risk of a house burning down in the even that it is not insured (one
sentence answer, the rest all maths no text)
Some ideas
, • Endowment effect
• Framing 50/50 gamble framed on gains or losses
• Investment appraisal, sunk costs
• Buy insurance + buy lottery tickets
• Life insurance vs annuities
• Organ donation
• NY taxi drivers
• Teacher incentives
• Cinema tickets (mental accounting)
We need to work out two things: the pain of buying the ticket and the potential joy that comes from
winning the lottery.
2)
(i) using probabilities (0.00001)
• V from buying ticket = -2 x 100.75 = -11.25.
• V from having ticket = 0.00001 x 7500.75 = 0.00001 x 25’486 = 0.255
▪ -11.25 + 0.255 = -11. V is negative; hence should not buy.
(ii) using decision weights (0.0060)
• V from buying ticket = -2 x 100.75 = -11.25.
• V from having ticket = 0.0060 x 25’486 = 15.29
▪ -11.25 + 15.29 = +4.04. V is positive; hence we expect the person to buy the ticket.
(iii) using probability values
• -2 x p0.75 = 0.255
• Hence, p = (0.255/2)1/0.75 = $0.0642, the amount they should be willing to pay
(iv) using decision weight values
• -2 x p0.75 = 15.29
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