Assignment:
You own a plant whose value is $100,000. In case of a fire, the value of your property might be significantly reduced or even destroyed, depending on how severe the accident is. Let us represent risk by the following scenarios:
Scenario Value ($) Probability
|
1
|
100,000
|
0.95
|
|
2
|
50,000
|
0.04
|
|
3
|
1
|
0.01
|
For each scenario, we have the value of your property and a probability. Clearly, in scenario 1 there is no fire and no loss. Assuming that your risk aversion is represented by a logarithmic utility function, what is the maximum insurance premium that you would be willing to pay? (Hint: The insurance would pay $0, $50,000, $99,999, respectively, in the three scenarios.)
Provide complete and step by step solution for the question and show calculations and use formulas.