Question

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?

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