Investments, tenth edition

6A.1 

   PROBLEMS: 

APPENDIX A 

    1.  Suppose that your wealth is $250,000. You buy a $200,000 house and invest the remainder in a 

risk-free asset paying an annual interest rate of 6%. There is a probability of .001 that your house 

will burn to the ground and its value will be reduced to zero. With a log utility of end-of-year 

wealth, how much would you be willing to pay for insurance (at the beginning of the year)? 

(Assume that if the house does not burn down, its end-of-year value still will be $200,000.)  

   2.  If the cost of insuring your house is $1 per $1,000 of value, what will be the certainty equivalent 

of your end-of-year wealth if you insure your house at: 

    a.   ½ its value.  

    b.   Its full value.  

    c.   1½  times  its  value.         

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6/18/13   8:08 PM

6/18/13   8:08 PM

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  C H A P T E R  

6

  Capital Allocation to Risky Assets  

203