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Alex is a risk adverse investor. He has $30,000 to invest for one year. He has two choices: Choice #1 : Buy shares of Paramount
Alex is a risk adverse investor. He has $30,000 to invest for one year. He has two choices:
Choice #1: Buy shares of Paramount Components Inc. (PC); which can payoff
- $ 1,600 if PC is in a high payoff state (H) and
- $ 0 if PC is in a low payoff state (L)
Choice #2: Buy a GIC with a guaranteed payoff of $ 64
Alexs prior probabilities on the future state of PC are:
P(H) = 0.30
P(L) = 0.70
Alexs utility is equal to the square root of the amount of the payoff.
Required: (Show all your calculations)
- Which choice of investment would Alex prefer; Shares of PC or GIC? (4 marks)
- Before making the investment Alex decides to become more informed. He studies the annual report of PC that has just been released and discovers that PC has had a Good year and the financial statement show Good news. Alex discusses his findings with an investment advisor who comes up with the following probabilities.
P(GN/L) = 0.1
P(GN/H) = 0.9
Prepare the information system (2marks),
Indicate which choice of investment will Alex now prefer? (4 marks)
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