Question

21. 3-22 Allen Young has always been proud of his personal investment strategies and has done very well over the past several years. He invests primarily in the stock market. Over the past several months, how- ever, Allen has become very concerned about the stock market as a good investment. In some cases it would have been better for Allen to have his money in a bank than in the market. During the next year, Allen must decide whether to invest $10,000 in the stock market or in a certificate of deposit (CD) at an interest rate of 9%. If the market is good, Allen 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%. Allen 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. (a) Develop a decision table for this problem. (b) What is the best decision? In Problem 3-22 you helped Allen Young determine the best investment strategy. Now, Young is thinking about paying for a stock market newsletter. A friend of Young said that these types of letters could pre- dict very accurately whether the market would be good, fair, or poor. Then, based on these predictions, Allen could make better investment decisions.

    1. (a) What is the most that Allen would be willing to pay for a newsletter?

    2. (b) Young now believes that a good market will give a return of only 11% instead of 14%. Will this in- formation change the amount that Allen would be willing to pay for the newsletter? If your answer is yes, determine the most that Allen would be willing to pay, given this new information.

Answer 1