Question

You are considering four projects that yield different payoffs, depending upon whether there is an economic boom or a recession. The probabilities, projects and corresponding payoffs are summarized in the following table.

Project	Boom 50%	Recession 50%
A	$ 40	-$20
B	-$10	$30
C	$50	-$50
D	$60	$60

a. What is the expected payoff of each project?

b. What is the variance of each project’s payoff?

c. What would be the expected payoff if you adopted projects A and B simultaneously?

d. Assuming you are risk-neutral, which project do you select? Does your answer change if you are risk-averse or risk-loving? Explain.

Answer 1

A) SEE SOLUTION IN THE PIC

B) SEE SOLUTION IN THE PIC

C) SEE SOLUTION IN THE PIC

D) A risk neutral person doesn't care about the amount of risk he is undertaking , he only cares about his expected payoff.

So, a risk neutral person will select project D since it gives him highest expected payoff.

A risk loving person likes to take risk only if expected return from taking risk is high.In this case,if he takes risk by investing in A,B or C project he will get lower payoff.So his optimal decision will be to choose project D.

A risk averse person doesn't like to take risks.Therefore,he will select that project for which variance of payoff is lowest.So,he also chooses project D since it is least risky.

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