Suppose you have just inherited $10,400 and are considering the following options for investing the moneyto maximize your return:Option 1: Put the money in an interest-bearing checking account that earns 3%. The FDIC insures the accountagainst bank failure.Option 2: Invest the money in a corporate bond with astated return of 6%, although there is a 10% chance thecompany could go bankrupt.Option 3: Loan the money to one of your friend’sroommates, Ayesha, at an agreed-upon interest rate of7%, but you believe there is a 7% chance that she willleave town without repaying you.Option 4: Hold the money in cash and earn zero return.a. If you are risk-neutral (that is, neither seekout nor shy away from risk), which of the fouroptions should you choose to maximize yourexpected return? (Hint: To calculate the expectedreturn of an outcome, multiply the probabilitythat an event will occur by the outcome of thatevent and then add them up.)b. Assume that Option 3 and Option 4 are your onlychoices. If you could pay your friend $50 to findout extra information about Ayesha that wouldindicate with certainty whether she will leave townwithout paying, would you pay the $50? Whatdoes this say about the value of better informationregarding risk?
Suppose you have just inherited $10,400 and are considering the following options for investing the money
to maximize your return:
Option 1: Put the money in an interest-bearing checking account that earns 3%. The FDIC insures the account
against bank failure.
Option 2: Invest the money in a corporate bond with a
stated return of 6%, although there is a 10% chance the
company could go bankrupt.
Option 3: Loan the money to one of your friend’s
roommates, Ayesha, at an agreed-upon interest rate of
7%, but you believe there is a 7% chance that she will
leave town without repaying you.
Option 4: Hold the money in cash and earn zero return.
a. If you are risk-neutral (that is, neither seek
out nor shy away from risk), which of the four
options should you choose to maximize your
expected return? (Hint: To calculate the expected
return of an outcome, multiply the probability
that an event will occur by the outcome of that
event and then add them up.)
b. Assume that Option 3 and Option 4 are your only
choices. If you could pay your friend $50 to find
out extra information about Ayesha that would
indicate with certainty whether she will leave town
without paying, would you pay the $50? What
does this say about the value of better information
regarding risk?
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