20. expected rate of return Ralph is contemplating loaning a cousin 10, 000. The loan would be due in one year, with interest at 18%. Ralph figures the probability the cousin will pay back the loan (plus interest) is .80; with probability .10 only the principal will be paid back; and with probability .10 nothing will be paid by the cousin. Ralph’s next best use of the 10, 000 is to invest it at the risk free rate of 4%. Ralph notes that the expected payment in one year is 10, 000(1.18)(.8) + 10, 000(.1) +
0(.1) = 10, 440. So, he concludes, the funds can be invested at 4%
or at 4.4%. The latter is a winner. Carefully discuss how Ralph has used the principles of consistent framing in reducing this to a comparison of expected interest rates. As a starting point, assume Ralph’s preferences are measured by the present value of expected wealth, and Ralph has a variety of investments in place.