Question

2. An investor who invests in the stock market has become doubtful about the stock market as a good investment. In some cases, it would have been better for him to have his money in a bank than in the stock market. During the next year, he must decide whether to invest OMR10,000 in the stock market or in a fixed deposit (FD) in a bank at an interest rate of 9%. If the market is good, he believes that he could get a 14% return on his money. With a fair market, he expects to get an 8% return. If the market is bad, he will most likely get no return at all—in other words, the return would be 0%. The investor estimates that the probability of a good market is 0.4, the probability of a fair market is 0.4, and the probability of a bad market is 0.2, and he wishes to maximize his long-run average return.

1. Develop a decision table for this problem.                                        
2. What is the best decision?  
3. Calculate the expected value of perfect information and interpret the result.                      
4. The investor is thinking about paying for a marketing company that could predict very accurately whether the market would be good, fair, or poor. What is the maximum amount of money that he should pay to the company?

Answer 1

this situation can be solved by calculating the standart deviation of the expected returns giving importance to probabilities alloted.

Economic condition	Rate (R)	Probability (P)	PR	R-E(R)	(R-E(R))2	P(R-E(R))2
Good	14	0.4	5.6	-3.2	10.24	4.096
Fair	8	0.4	3.2	-5.6	31.36	12.544
Bad	0	0.2	0	-8.8	77.44	15.488
						32.128

E(R)= ∑PR 8.8

standard deviation = Square root of 32.128

= 5.67%

it will be better to invest in bank deposit as it will provide a consistent 9% return. The economic condition in this is not favourable as it provides only 5.67% on an average.