Question

Please solve in excel

.A young couple has $28,000 (90% of their savings) to invest in either savings bonds or a real estate deal. The (zero coupon) savings bonds return $35,000 ($7,000 interest) in three years. The (completely liquid) real estate investment, after three years, is worth $66,000 if economic conditions are good (70% chance), and worth nothing ($0) if economic conditions are bad (30%). The couple decides to invest in the savings bonds.

What do you know about the certainty equivalent (for the couple) of the real estate investment?   HINT – Make sure you understand the concept of certainty equivalence.

What would you do in these circumstances?

Give me an example of a different set of probabilities that would change your decision in b”.

Answer 1

				R	P	EV = R*P
Condition		Investment		After 3 years	Probability	Expected value
		28000
	Option A		Interest	Total return
	Savings bond	28000	7000	35000	1	35000
Good	Option B
	Real Estate	28000		66000	0.7	46200
Bad
		28000		0	0.3	0
					Total EV= Good +Bad	46200

So we see if the risk premium is R

Then 46200/(1+R)^3 = 35000

1+ R =

1.09696131

SO R = 9.696% (Certainty equivalent rate)

So in this case as the returns are higher in real estate in probabilistic terms that is a better option.