Reference no: EM13375237

Your company maintains a surprisingly large presence in the tiny country of Liechtenstein. The Prince of Liechtenstein has just ruled on a proposed law that - if approved - would dramatically affect the effectiveness of your new benefits program. As far as you can tell, only the Prince and a cadre of Liechtensteinian Ministers know whether the Prince has chosen to approve the law. Just prior to the vote, you believed there was a 70% chance that the Prince would approve the law and a 30% chance that he wouldn't. A colleague of yours wants to bet you $100 that the law didn't pass. You can either refuse to bet or you can bet that the law did pass. (That is, you can't bet that it didn't pass.) Assume for (a) and (b) that you are risk neutral.

a) Before you decide whether to bet, you have the opportunity to make a quick call to a friend of yours, who also happens to be a Liechtensteinian Minister. Would it be worth $50 to call the Minister, assuming he'll truthfully tell you the result? Be sure to show the decision tree that fuels your reasoning.

b) Another friend of yours is a good friend of the Prince, and you think there's a 70% chance she already knows whether the law passed. If she knows, she will tell you the result. What is the most you would pay to call her and ask for the result? Be sure to show the decision tree that fuels your reasoning.

c) Would your answer to (a) change if you were risk averse? If so, how? If not, why not? Please clearly delineate how you are applying risk aversion to the tree you drew in part (a).