Global Gas International offers to contract the Halidurton Heavy Construction Co

Question

Global Gas International offers to contract the Halidurton Heavy Construction Corporation to build an oil pipeline from Canada to New Orleans that will provide Halidurton $600 million in income. The probability that the oil pipeline will leak, causing environmental damage is 0 . If so, the legal liability will be $3,000 million. If Halidurton is risk neutral and liable for the damages from a leak, what is the 0 such that it is indifferent between accepting and rejecting the contract?

Halidurton is indifferent between accepting and rejecting the contract if 0 equals _______percent.

Explanation / Answer

Given, the probability (P) = 0

Now the utility (U) of P has to be calculated as below:

U (P) = (Liability cost / Income) × r

U (0) = ($3,000 million / $600 million) × r

U (0) = 5r

Now the first-order derivative of U with respect of r,

Derivative of U = 5

Now the second-order derivative of U with respect of r,

Derivative (2nd) of U = 0

The person is risk neutral, since the 2nd order derivative is equal to 0.

If the required probability is 0% the person would be indifferent, since the cost of $3,000 will not appear in either way.

Answer: 0 percent

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