Business Economics II

Group 21 Núria Solana 1426004

Núria Sánchez 1426153
Mariona Domingo 1425916

HOMEWORK 4

EXERCISE 1:

Two risk-averse entrepreneurs (1 and 2) have the same Arrow-Pratt risk aversion
coefficient  = 0.017/Euros. The cash flows associated to their respective firms are
summarized in the following boxes:

1) Determine the value that each owner assigns to her firm if they are not related to
any other element of her wealth.

Project 1:

𝜇 1 = 150€ · 0.4 + 100€ · 0.3 + 70€ · 0.3 = 111

𝜎21 = 0.4 · (150 – 111)2 + 0.3 · (100 – 111)2 + 0.3 · (70 – 111)2 = 1,149

0.017
CE1 = 111 - · 1,149 = 101.23
2

Project 2:

𝜇 2 = 130€ · 0.2 + 110€ · 0.3 + 80€ · 0.5 = 99

𝜎22 = 0.2 · (130 – 99)2 + 0.3 · (110 – 99)2 + 0.5 · (80 – 99)2 = 409

0.017
CE2 = 99 - · 409 = 95.52
2

2) The joint probability of both projects is distributed according to the following

table:

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Business Economics II
Group 21 Núria Solana 1426004
Núria Sánchez 1426153
Mariona Domingo 1425916

a) Check that the covariance between the two projects is -599. How much would be
entrepreneur 1 willing to pay for firm 2? Explain.

Cov(I1, I2) = 0 · (150 – 111) · (130 · 99) + 0 · (150 – 111) · (110 · 99) + 0.4 · (150 – 111)
· (80 – 99) + 0 · (100 – 111) · (130 – 99) + 0.2 · (100 – 111) · (110 – 99) + 0.1 · (100 –
111) · (80 – 99) + 0.2 · (70 – 111) · (130 – 99) + 0.1 · (70 – 111) · (110 – 99) + 0 · (70 –
111) · (80 – 99) = - 599

𝛾 0.017
CE1+2 = 𝜇 (1+2) - 2 · 𝜎2(1+2) = 111 + 99 - · [1,149 + 409 + 2 · (-599)] = 206.94
2

CE1+2 – CE1 = 206.94 – 101.23 = 105.71

The entrepreneur 1 is willing to pay 105.71 for firm 2.

b) What would be the value of an integrated firm?

𝛾 0.017
CE1+2 = 𝜇 (1+2) - 2 · 𝜎2(1+2) = 111 + 99 - · [1,149 + 409 + 2 · (-599)] = 206.94
2

c) What would be more convenient: the integration of the two firms or that the two
firms remain independent? Justify your answer.

CE1 + CE2 < CE1+2 → 196.75 < 206.94

So, it is more convenient the integration of the two firms as the value of the integrated
firms is higher than the value of the two firms independent.

EXERCISE 2:

An entrepreneur is talking to two different firms to start up a business ZZ, that would give
them some expected profits ß = 100. The project has a high level of risk, where  2 =
120 is the variance of the profits and we will also assume that the profits of this project
are not correlated with any of the considered businesses. The firms differ in their shares
structure. Firm A is a firm where a rich entrepreneur has concentrated all her wealth and
she owns 100% of it. By contrast, firm B is a multinational firm with one million
shareholders. Every shareholder has the same certainty equivalent expression EC = 𝑦̅ −

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Business Economics II
Group 21 Núria Solana 1426004
Núria Sánchez 1426153
Mariona Domingo 1425916

𝑦
· var(y), where 𝑦̅ and var(y) are, respectively, the expected value and the variance or the
2
rents (y), while  denotes the Arrow-Pratt risk aversion coefficient that we will assume is
equal for all of them and also for our entrepreneur, being  = 2.

a) How does each firm value the business project ZZ? Discuss the differences.

Since we don’t know the utility functions of each firm, we can only analyze using the
Certainty Equivalence with the given values: 𝜇𝛽 =100, 𝜎𝛽2 =120, and 𝛾=2.
The valuation of the project is different in both firms since firm A is 100% owned by a
single person so the risk will be absorbed fully by the rich entrepreneur, while firm B is
a multinational firm with a million shareholders, thus the risk is distributed among them
and so it’s minimized.

b) Will the two firms be interested in the business project? Discuss briefly.

Both firms have the Arrow-Prat coefficient >0, then both firms would be willing to accept
an amount of money lower or equal than the expected value, just for not taking risk.
Firm A: the risk is not shared
𝛾 2
𝐶𝐸𝐴 = 𝜇𝛽 − · 𝜎𝛽2 = 100 − · 120 = −20
2 2
- For firm A we have a negative certainty equivalent but we are talking about
money to be received, thus we can interpret it as the firm would not be willing to
accepting any amount, so it’s not interested on the project ZZ.
Firm B: shared risk among 1,000,000 shareholders
𝛾 1 2 2 1
𝐶𝐸𝐵 = 𝜇𝛽 − · · 𝜎𝛽 = 100 − · · 120 = 99.98 ≈ 100
2 𝑛 2 1,000,000
- In this case, the amount of money that would make firm B indifferent between
accepting the project or just getting the money is almost the same as the
expected value. The firm has the same risk aversion as firm A but, in this case,
given that the risk is shared, the company might be willing to accept the project
ZZ.

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Business Economics II
Group 21 Núria Solana 1426004
Núria Sánchez 1426153
Mariona Domingo 1425916

c) Finally, for what values of the risk aversion coefficient  of the entrepreneur A
would we obtain that firm A values more the project ZZ than firm B. Justify and
analyze your answer.

We are going to put the following condition:

CEA > CEB, having 𝛾 as the unknown variable to be determined.
We have that
𝛾 𝛾
𝐶𝐸𝐴 = 𝜇𝛽 − 2 · 𝜎𝛽2 = 100 − 2 · 120 = 100 − 60𝛾
𝛾 1 2 𝛾 1
𝐶𝐸𝐵 = 𝜇𝛽 − · · 𝜎𝛽 = 100 − · · 120 = 100 − 0.00006𝛾
2 𝑛 2 1,000,000
100 − 60𝛾 > 100 − 0.00006𝛾
−60𝛾 > −0.00006𝛾
0 > 59,99994𝛾
𝜸<𝟎
The risk aversion coefficient should be lower than zero to make firm A value more the
project ZZ than firm B.
So, the solo entrepreneur need to have a risk-loving attitude in order to accept the project,
this also means that the CE will be higher than the expected value of the project (>100).
EXERCISE 3:

The Brazilian football federation has contracted an insurance policy with the insurer
Ipanema. According to this insurance policy, if Brazil wins the 2018 World Cup, the
insurer will take charge of the 10 million dollar bonuses that Brazil agreed with the
players. The estimated winning probability for Brazil is 50%. The insurer has a risk
aversion coefficient of 0.08/million dollars and it has not any other section insured.

a) Calculate the monetary value of this insurance policy for Ipanema. What can be
said about the risk aversion coefficient of the Brazilian football federation? Take
into account that it has already signed the contract and that it has no other risk on
her patrimony.

𝜇 = 0.5 · (-10) + 0.5 · 0 = - 5

𝜎2 = (-10 + 5)2 · 0.5 + (0 + 5)2 · 0.5 = 25

0.08
CE = -5 - · 25 = - 6
2

When the risk aversion coefficient is positive means that the position towards risk of the
insurer is risk aversion.

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Business Economics II
Group 21 Núria Solana 1426004
Núria Sánchez 1426153
Mariona Domingo 1425916

We can corroborate it also comparing the CE with the 𝜇. The CE being smaller than the
𝜇 is another factor of a risk aversion person. ( -6 < -5).

The Royal Spanish Football Federation (RFEF) contacts Ipanema because it is also
interested in ensuring the 15 million-dollar bonuses of its players in case they win
the World Cup. The estimated winning probability for Spain is 10%.

𝜇 Spain = -15 · 0.1 + 0 · 0.9 = - 1.5

𝜎2Spain = (-15 + 1.5)2 · 0.1 + (0 + 1.5)2 · 0.9 = 20.25

b) Check that the covariance between the two lotteries is –7.5. Explain the sign.

LSpain
LBrazil C1 = -15 C2 = 0
B1 = - 10 P 11 = 0 P12 = 0.5
B2 = 0 P 21 = 0.1 P 22 = 0.4

𝜇 Brazil = -5; 𝜎2Brazil = 25

𝜇 Spain = - 1.5; 𝜎2Spain = 20.25

Cov(LBrazil, LSpain) = (-10 + 5) · (-15 + 1.5) · 0 + (-10 + 5) · (0 +1.5) · 0.5 + (0 + 5) · (-15

+ 1.5) · 0.1 + (0 + 5) · (0 + 1.5) · 0.4 = -7.5

The negative sign in the covariance means that the two variables have an inverse
relationship. Higher values of one are associated with lower values of the other.

c) Calculate the minimum price that Ipanema is willing to accept to insure the
Spanish team, taking into account that it has already insured the Brazilian team.
0.08
CESpain = -1.5 - · 20.25 = -2.31
2

0.08
CEBrazil + Spain = - 5 – 1.5 - · [25 + 20.25 + 2 · (-7.5)] = - 7.71
2

CEBrazil + Spain - CESpain = - 7.71 + 2.31 = - 5.4

Ipanema is willing to accept a minimum price of 5.4M.

d) Suppose that the RFEF has a risk aversion coefficient of 0.08/million dollars. Will
they reach an agreement if the insurer has the same risk aversion coefficient? Why?
If so, and if the bargaining power is 50%, what will be the final price of the
insurance? Justify your calculations.

Yes, because

5
Business Economics II
Group 21 Núria Solana 1426004
Núria Sánchez 1426153
Mariona Domingo 1425916

EXERCISE 4:

Search and find two recent newspaper articles related to this chapter. Provide a link and
write a paragraph with the explanation of why you have chosen them. (Try to find
examples with some numerical figures that we could use for the analysis).
Extra scoring: Elaborate a proposal for a numerical exercise related to the selected piece
of news.

I- An increase in uncertainty in Catalonia could have "adverse economic

effects" from newspaper Expansión

http://www.expansion.com/economia/2018/05/03/5aeadaf322601d9d578b45df.html

The Bank of Spain says that "although the financial tensions surrounding the political
situation in Catalonia have been reduced, it can not be ruled out that an eventual increase
in uncertainty could have adverse economic effects."

In this piece of new, the journalist explains that due to political uncertainty in Catalonia ,
the economy could be affected in that region and also in the whole country.

When we live uncertainty (not just measured by the political situation, also by other
factors), people tends to spend less money because of the potential risk they are assuming
by getting mortgaged without a stable situation.

Therefore, it fits with the topic we are working with because explains how the presence
of uncertainty affects the economy and how it involves risk.

II- The irrational chance of the Christmas Lottery from El País

https://politica.elpais.com/politica/2014/12/05/actualidad/1417781665_285477.html

This article talks about superstition in people who spends a huge amount of money in a
single lottery number because of their feeling about it. Explaining that, all numbers have
the same probability of being awarded.

However, the article explains that is not useless playing that game because of the utility
function generated: 20 euros does not mean too much in our life to invest. However,
winning would make a big difference to the buyer. The utility function is clear; it's a low
probability, yes, but not ridiculous. There you have to think not only about the
mathematical factor, but also about the psychological or behavioral factor of the buyer.

As we can see, the article relates the personal behavior with the risk of losing money and
the uncertainty created when buying a lottery number.

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Business Economics II
Group 21 Núria Solana 1426004
Núria Sánchez 1426153
Mariona Domingo 1425916

III- Extra score related with the lottery article:

We assume that if a buyer wins the lottery with a single lottery number, will win
400,000€.

The probability of winning that award with a single lottery number is 1 over 100,000
(100,000 numbers), meaning that probability of winning is of 0,00001%.

What is more, it presents risk aversion coefficient of 0,02/hundred euros.