Assignment 5_ERA

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Northeastern University *

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SD

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Economics

Date

Feb 20, 2024

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docx

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2

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a) What is the investor’s optimal decision under the EMV rule? What is the EMV of the investment opportunity? Answer: The best decision for the investor in terms of boosting EMV is to purchase the property with the consultant service. (Hire Consultant). The investor should expect an EMV of 450,000. b) Assume the investor has a risk tolerance of $2 million. Using the utility curve we discussed in class, what is his optimal decision? What is the certainty equivalent of that decision? Answer: If the investor has a risk tolerance of 2 million and the previously described utility function exists, the investor's optimal decision would still be to acquire the property with the consultant service (Hire Consultant) with U(x) equal to 0.2873. Therefore, the Certainty Equivalent of that decision is around 562,050. c) As it turns out, the consultant was just joking about bribing the government; this is not a decision alternative after all. What is the expected value of the information the consultant can provide? Answer: The determined EMV from the choice to hire the consultant given the conditional probability that was derived before is the expected value of the information the consultant can supply. The projected value of the information provided by the consultant is around $450,000.
d)Now assume, instead of knowing exactly what his payoffs and liabilities are, he only knows that they’ll be lognormally distributed, with mean and sd according to the following table: Outcome Payoff Liability Rezone: Bidding war μ = $ 3 M ,σ = $ 0.6 M - Rezone: Sell to developer μ = $ 1.8 M ,σ = $ 0.36 M - Rezone: Sell w/out developer μ = $ 0.7 M ,σ = $ 0.14 M - Fail: Resell μ = $ 0.3 M ,σ = $ 0.06 M - Fail: Unsellable - μ = $ 0.1 M ,σ = $ 0.2 M Caught attempting bribery - μ = $ 1.5 M ,σ = $ 0.3 M He still knows the exact costs of purchasing the property, bribing officials, and paying the consultants’ fees. What is the probability the speculator will lose at least $200 thousand assuming he acts according to the EMV rule, as in part (a)? Answer: According to Monte Carlo simulation with 10,000 iterations. It was discovered that there are approximately 31 possibilities out of 10,000 iterations in which the investor will lose at least 200,000 USD. So, the calculated probability is P = 31/10000 = 0.0031 or 0.31%
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