Midterm 1 formula sheet, helpful hints, pre-exam office hours

I just posted the formula sheet for the Midterm 1 exam, which will be administered during class on Thursday, February 25. Actually, the formula sheet consists of two pages; the first page is a formula sheet, and the second page is a standard normal distribution table.

The exam consists of 3 problems worth 32 points each; I add 4 points to everyone’s scores so that that the maximum number of points possible is 100. On Thursday, plan on allocating no more than 80 minutes to complete the exam, and no more than 10 minutes to upload a single PDF of your written work which clearly demonstrates your conceptual grasp and ability to clearly explain, in plain English, how you arrived at all of your answers on the exam.

You may use either a calculator or a spreadsheet for any computations that are required for the exam; please keep in mind the Official Finance 4335 Course Policy Concerning the Use of Excel for Problem Sets and Exams.

Here are some (what I think are) helpful hints:

1. Review definitions for risk aversion, risk neutrality, and risk-loving behavior; see especially page 2 of http://fin4335.garven.com/spring2021/lecture6.pdf about these topics:

• Risk-averse utility functions are characterized by diminishing marginal utility; thus, E(U(W)) < U(E(W));
• Risk-neutral utility functions are characterized by constant marginal utility; thus, E(U(W)) = U(E(W)); and
• Risk-loving utility functions are characterized by increasing marginal utility; thus, E(U(W)) > U(E(W)).

2. Full coverage insurance: Under a “full coverage” policy, the insured pays a premium that transfers all risk to the insurer; if the premium charged for such coverage is actuarially fair, then the optimal choice for all arbitrarily risk-averse decision-makers is to purchase a full-coverage policy; this result is commonly referred to as “Bernoulli Principle” (see http://risk.garven.com/2021/02/22/actuarially-fair-price-of-insurance-policy/).

3. Degree of risk aversion. For logarithmic and power utilities, we saw that all such utilities feature decreasing absolute risk aversion, which means that as one’s initial wealth increases, the one’s degree of aversion to a given risk declines; resulting in a lower risk premium at higher levels of initial wealth (see pp. 9-12 of http://fin4335.garven.com/spring2021/lecture6.pdf).

On Wednesday, I plan to be available in my virtual Zoom office from 3-5 pm CT in case if any students would like to stop by for a pre-exam chat.

Good luck!