DIMINISHING MARGINAL UTILITY -
(A) The utility you receive from mney follows this chart:
DOLLARS | UTILITY |
1 | 200 |
2 | 300 |
3 | 380 |
4 | 440 |
5 | 480 |
Your current government bonds pay you a return of $3 per month. You can sell them and buy a stock that has a fifty percent chance of paying $4 per month and a fifty percent chance of paying $2 per month.
Why would you not make that exchange? Why would you be even less interested in a stock that had a fifty percent change of paying $5 per month and a fifty percent chance of paying $1 per month? (PLEASE INCLUDE FORMULAS USED TO SOLVE PROBLEM FOR EXCEL).
(B) ADDING AN ASSET TO A PORTFOLIO -
Your current portfolio's cash returns over the past three years looked like this:
YEAR 1 | YEAR 2 | YEAR 3 | E(CF) | o | |
Your Portfolio CF's | 100 | 100 | 100 | 100 | 0 |
The past three years are representative of a good year, an average year, and a bad year for you. You are considering adding one of these two equally priced assets to your portfolio:
YEAR 1 | YEAR 2 | YEAR 3 | E(CF) | o | |
New Asset 1 | 2 | 6 | 10 | 6 | 4 |
New Asset 2 | 10 | 6 | 2 | 6 | 4 |
You would be indifferent between these two assets even though they have different cash flows. Why? (PLEASE INCLUDE FORMULAS USED TO SOLVE PROBLEM FOR EXCEL).
A).The utility that a person currently gets if government pays $3 is 380
If you have 50% chance of getting $4 per month and 50% percent of getting $2 per month:
Utility : (50% * 440) + (50% * 300) = 370 since this is less than 380 hence they won't buy a stock that pays $4 per month and that pays $2 per month.
If you have 50% chance of getting $5 per month and 50% percent of getting $1 per month:
Utility : (50% * 480) + (50% * 200) = 340 since this is less than 380 hence they won't buy a stock that pays $5 per month and that pays $1 per month.
B). Since the future expected cashflows from both the assets are $6 & $4 for both the future years hence any investor would be indifferent between choosing any of the assets.
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