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Chapter1: Financial Statements And Business Decisions
Section: Chapter Questions
Problem 1Q
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Question
In the upcoming year, the income from your current job will be $50,000. There is a 0.5 chance that you will keep your job and earn this income, and 0.2 chance that you will get a rise and earn 75,000. However, there is 0.3 chance that you will be laid off, putting you out of work for a time and forcing you to accept a lower paying job. In this case, your income is $25.000. The expected value of your income is thus $47,500.
a) If your utility function has the formula 500I - 0.0002I2, determine the risk premium associated with this lottery.
b) Provide an interpretation of the risk premium in this particular example.
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