Question

# Tom sold his old house in upstate New York and now has a sum of \$175,000...

Tom sold his old house in upstate New York and now has a sum of \$175,000 for investment. Tom is considering select only one of the three possible investments to invest his \$175,000: a mutual fund (MF), a technology stock (TS), or a certificate of deposit (CD). The investment industry estimates the probability of a good, average, and poor market to be 42%, 27%, and 31%, respectively. The CD is guaranteed to pay a 3.5% return regardless of the market condition. The financial consultant estimates the return on the mutual fund (MF) as 7%, 2%, or -3%, depending on whether market condition is good, average, or poor, respectively. Under the same condition, the financial consultant estimates the technology stock (TS) would yield 9%, 5%, or -11%.

Construct a payoff table (in dollars) for Tom's investment return. What decision should be made according to the optimistic approach?

 Market Conditions Probability Return on Mutual Fund Return on TS Expected Return On MF Expected Return on TS (a) (b) (c) (d) =b*c =b*d Good 0.42 7% 9% 2.94% 3.78% Average 0.27 2% 5% 0.54% 1.35% Poor 0.31 -3% -11% -0.93% -3.41% Total 2.55% 1.72%

Return:

• Mutual Fund = 2.55%* \$175,000 = \$ 4,462.50
• TS. = 1.72%* \$175,000 = \$ 3,010
• CD. = 3.5%* \$175,000 = \$ 6,125

The highest return is received in terms of Certificate of deposit and hence Tom should invest in CD

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