Nicole is indifferent between option A, which gives her $20,000 for sure, and option B, which gives her $10,000 with probability 0.5 or $32,000 with probability 0.5. Nicole's cost of risk for option B is
A) zero.
B) $1,000.
C) $2,000.
D) $20,000.

Question

Quizplus · Accepted Answer

Nicole's cost of risk is the difference between the expected value of option B and the certain amount she would accept instead (option A). The expected value of option B is $21,000 (0.5*$10,000 + 0.5*$32,000). Since she is indifferent between $20,000 for sure and option B, her cost of risk is $21,000 - $20,000 = $1,000.

Nicole Is Indifferent Between Option A, Which Gives Her $20,000