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?

Homework Answers

Answer #1

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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