Question

Mary Johnson recently received a lump sum of $240,000 after selling her old house in upstate New York. Mary would like to invest this amount of money. Her local bank offers Mary an available Gold Client account for her entire $240,000 deposit that guarantees 3.75% return regardless of the future market climate. Mary is also interested in investing her $240,000 in two stock options. The first one is to spend the entire $240,000 to purchase stocks from EliteCure, an upcoming pharmaceutical manufacturer. The projected return for EliteCure stock is 17%, 9%, -2%, -20%, respectively, depending on the future market climate to be excellent, good, poor, or disastrous. The other one is to spend her $240,000 to purchase stocks from AcutePro, a well-established pharmaceutical manufacturer. The projected return for AcutePro stock is 11%, 10%, 7%, -5%, respectively, depending on the future market climate to be excellent, good, poor, or disastrous. The stock industry considers many current economic events and estimates 40% chance to have an excellent future market while the remaining 60% chance to be evenly distributed among the other three (good, poor, or disastrous) possible future markets.

(Question 1) Construct a payoff table (in dollars) for Mary Johnson.

(Question 2) What decision should Mary make according to the expected value approach?

(Question 3) Create a regret table for Mary. What decision should Mary make according to the minimax approach?

(Question 4) What decision should Mary make according to the optimistic approach?

(Question 5) How much should Mary be willing to pay to obtain a market forecast that is perfectly accurate?

Answer 1

Answer 1
	Payoff Table
Option	Investment in Bank (1)	Elite Cure (2)	AcutePro(3)
Return	=$240,000 * 3.75%	=$240,000* 4.2%	=$240,000* 6.8%
	$                          9,000.00	$          10,080.00	$          16,320.00

Note

1.Calculation of Elite Cure Rate = 17%*40% + 9%*20% +(-2%)*20% +(-20%)*20% = 4.2%

2.Calcluation of AcutePro Rate = 11%*40% + 10%*20%+ 7%*20% +(-5%)*20% = 6.8%

Answer 2

According to expected value approach option 3 i.e. investment in shares of AcutePro should be best for Mary Johnson

Answer 3

According to the maximin approach Mary should invest in option 1 i.e. investment in bank , since she will get assured return of 3.75% regardless of future market climate.

Answer 4

According to the optimistic approach Mary should invest in option 3 i.e. investment in shares of AcutePro

Answer 5

Mary would willing to pay $ 1,080 ( $10,080 - $9,000) to obtain a market forecast that is perfectly accurate.