Topic
3:
Pricing
Risky
Assets
1
Consider
three
possible
lo:ery
;ckets
with
the
following
payoffs
in
1
year:
1%
$100
mil
Ticket
A:
1%
chance
of
paying
off
$100,000,000
99%
of
paying
off
$0
$0
mil
99%
Ticket
B:
50%
$2
mil
50%
chance
of
paying
$2,000,000
50%
chance
of
paying
$0
$0
mil
50%
Ticket
C:
100%
100%
chance
of
paying
$1,000,000
$1
mil
From
previous
lectures,
we
know
that
the
price
you
are
willing
to
pay
today
for
each
;cket
is
the
expected
payoff
next
year
discounted
back
to
today.
Price
=
E[Payoff]/(1+r)
where
r
is
the
required
rate
of
return
on
this
;cket.
What
is
the
expected
payoff
of
each
;cket?
2
Risk
Aversion
§ Risk-‐averse
agents
prefer
a
certain
outcome
to
an
uncertain
outcome
with
the
same
expected
payoff.
Large
majority
of
people
are
risk-‐averse
§ Risk-‐neutral
agents
are
indifferent
between
certain
and
uncertain
outcomes
with
the
same
expected
payoffs.
Risk-‐seeking
agents
prefer
an
uncertain
outcome
to
a
certain
outcome
with
the
same
unexpected
payoffs.
§ The
Certainty
Equivalent
of
a
gamble
is
the
amount
you
would
be
willing
to
receive
with
100%
certainty
to
be
indifferent...