How good is the P-A approximation of the risk premium for “large” risks.
a) The risky wealth is: ($120K,$100K,$40K) with probabilitie (0.3,0.6,0.1). Compute the expected utility and the exact RP of a log-utility investor.
b) Compute the mean, variance and standard deviation of wealth for this distribution. Compute the approximate P-A $RP of the log utility investor.
c) Is the Pratt-Arrow RP a good approximation? How large is the coefficient of variation of wealth? Is the risk a large fraction of wealth here?