1. In many financial transactions, one party sells risk and the other buys it. Discuss an example that illustrates this point, making clear why it is financially sensible for the purchaser of the risk to want do this. Your example can either concern a consumer's purchase of a life insurance policy, or an investor's purchase of a common stock (both examples discussed in class), or some other example of your own choosing. (one paragraph answer)

2. In class we did a simple experiment first done in the 1950s by Allais, and reported by Kahneman and Tverskey in their 1979 paper. This experiment involved asking all of the students in the class to make a choice between: (1a) $6000 with 45% probability , or (1b) $3000 with 90% probability. Then the all the students were put to a second choice, between (2a) $6000 with 0.001 probability, and (2b) $3000 with a 0.002 probability.

2a. What did our results demonstrate? That is, state the major conclusion that one can draw from this experiment.

First answer: When the probability of a favorable outcome is tiny, most people make the choice having the largest potential gain. By contrast, when the probability of a favorable outcome is large, most people make the choice having the largest probability of a favorable outcome.

Second answer: Most people, when faced with a choice involving a tiny probability of a favorable outcome do not act in the same way that they would when faced a choice involving a large probability of a favorable outcome. There appears to be no rational reason for such behavior.

2b. In what way is the experiment described in 2a replicated? (one sentence answer)

Answer: The entire class participated, hence more than one individual made the choices.

2c. With regard to the experiment described in 2a, Craig asked in class that the students, in making the choices, not consider what they had learned in the last several classes about risk perception. The need for this direction would be obviated had the experiment been done _________. (Fill in the blank.) Because this was not done, the results of this experiment may not be a good __________ (Fill in the blank) of how VLS students in general would behave when faced with similar choices.

Answers: blind; model

2d. It has been hypothesized that many people are risk seeking with respect to choices that involve potential losses, but are risk averse with respect to choices that involve potential gains. Modify the experiment described in 2a, so that as to test this hypothesis. (one or two paragraph answer)

Answer: First choice: (1a) sure loss of $1000, and (1b) 80% chance of losing $1250 and a 20% chance of losing nothing. Second choice: (2a) sure gain of $1000, and (2b) 80% chance of winning $1250 and a 20% chance of winning nothing.

2e. With respect to the experiment you designed in 2d, what results would falsify your a priori hypothesis? (one sentence to one paragraph answer)

2f. With respect to the experiment you designed in 2d, what results would support your a priori hypothesis? (one sentence to one paragraph answer)