Money and Banking

Applied Problems p97 No.24

24. Suppose you have just inherited $10,400 and are considering the following options for investing the money to maximize your return:

Option 1: Put the money in an interest-bearing checking account that earns 3%. The FDIC insures the account against bank failure.

Option 2: Invest the money in a corporate bond with a stated return of 6%, although there is a 10% chance the company could go bankrupt.

Option 3: Loan the money to one of your friends roommates, Ayesha, at an agreed-upon interest rate of 7%, but you believe there is a 7% chance that she will leave town without repaying you.

Option 4: Hold the money in cash and earn zero return.

1. If you are risk-neutral (that is, neither seek

out nor shy away from risk), which of the four options should you choose to maximize your expected return? (Hint: To calculate the expected return of an outcome, multiply the probability that an event will occur by the outcome of that event and then add them up.)

2. Assume that Option 3 and Option 4 are your only choices. If you could pay your friend $50 to find out extra information about Ayesha that would indicate with certainty whether she will leave town without paying, would you pay the $50? What does this say about the value of better information regarding risk?