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