Market analysts believe that the market value of stock ABC either increases to 180 or drops down to 20, with equal probability, a year from now. No dividends will be paid to shareholders during the coming year. Assume you are an investor with utility-function U = π 1/2 where π represents your utility of the ABC stock’s end-of-year market value.
(a) Given your risk-aversion; how much are you willing to pay for the stock today?
(b) Given your certainty equivalent (or reservation-price) calculated above, what is the riskpremium you are demanding in order to participate in the gamble of purchasing the ABC-stock today?
(c) Would a utility-function U = π 2 change your risk-premium calculated above in any way? Briefly explain your answer.