7, Suppose that two investments have the same three payoffs, but the probability associated with each payoff differs, as illustrated in the table below: Probability Payoff (nvestment A) $300 0.10 $250 0.80 $200 0.10 a. Find the expected return and standard deviation of each investment. ‘The expected value of the return on investment A is, EV = (0.1)(300) + (0.81230) + (0.1(200) = $250. ‘The variance on investment Ais 62 = (0.1)(300 - 2503° + (0.8250 - 25098 + (0.1)(200 - 250)? = $500, and the standard deviation on investment A is o = 500 =a ‘The expected value of the return on investment B is EV = (0.3300) + (0.4)(20) + (0.8)(200) = $250, ‘The variance on investment Bis 62 = (0.31300 - 25032 + (0.4)(250 - 25002 + (0.3200 - 250)? and the standard deviation on investment Bis: i500 = $38.73. ‘I, where I denotes the payoff. Which investment Sil’ expected utility from investment Ais EU= (0.1)[51800) + (0.8)[5(250)] + 0.1)[5(200)] = 1250. Jil's expected utility from investment B is EU=0.3){5(800) + (0.4)[5250)] + (0.3){5200)] = 1250. Since both investments give Jill the same expected utility she will be indifferent between the two. Note that Jill is risk neutral, 20 she cazes only about expected values. Since investments A and B have the same expected values, she is indifferent between them. Ken has the utility funetion 7 = 5 . Which investment will he choose? Ken's expected utility from investment Ais EU = (0.196 ¥300 ) + (0.8)(6 ¥250 ) + (0.1)(6 200 ) = 78.98. Ken's expected utility from investment Bis, EU=(0.3)(5 ¥300 ) + (0.4)(5 V250 ) + (0.3) V200 ) = 78.82. Ken will choose investment A because it has « slightly higher expected utili Notice that Ken is risk averse. so he prefers the investment with less variability. Laura has the utility function U = 5/°, Which investment will she choose? Laura's expected utility from investment Ais EU=(0.1)[5(300%] + (0.8)[5250%)] + (0.1)[5(200%) Laura's expected utility from investment Bis EU=(0.3)[5(8002] + (0.4)[5(250%) + (0.3)15(2002] = 320,000. Laura will choose investment B since it has a higher expected utility. Notiea that Laura is a risk lover. so she prefers the investment with greater variability. 15,000.‘8. As the owner of a family farm whose wealth is $250,000, you must choose between sitting this season out and investing last year’s earnings ($200,000) in a safe money market fund paying 5.0 percent or planting summer corn. Planting costs $200,000, with six-month time to harvest. If there is rain, planting summer corn will yield $500,000 in revenues at harvest. If there is a drought, planting will yield $50,000 in revenues. As a third choice, you can purchase AgriCorp drought-resistant summer corn at a cost of $250,000 that will yield $500,000 in revenues at harvest if there is rain, and $350,000 in revenues if there is a drought. You are risk averse, and your preference for family wealth GW) is specified by the relationship UP) =F . The probability of a summer drought is 0.30, while the probability of summer rain is 0.70. Which of the three options should you choose? Explain. Calculate the expected utility of wealth under the three options. Wealth is equal to the initial $250,000 plus whatever is earned growing corn or investing in the safe financial asset. Expected utility under the aafe option, allowing forthe fact that your initial wealth is $250,000, is: E(U) = (250,000 + 200,000 + .05))5 = 678,23. Expected utility with regular corn, again including your initial wealth, is: E(L) = .7(250,000 + (600,000 — 200,000))5 + .3(250,000 + (60,000 — 200,000))s = 519.13 + 94.87 = 614. Expected utility with drought-resistant corn is: E(L) = .71200,000 + (500,000 — 230,000))5 + .8(250,000 + (350,000 — 250,000))s = 494.975 + 177.482 = 672.46. ‘You shoul choose the option with the highest expected utility, which is the safe option of not planting corn, Note: There is a subtle time issue in this problem. The returns from planting corn occur in 6 months while the money market fund pays 5%, which is presumably a yearly interest rate. To put everything on equal footing. we should compare the returns of all three alternatives over a G-month period. In this case. the money ‘market fund would ean about 2.5%, so its expected utility i: E(U) = (250,000 + 200.0001 + .025))5 = 674.54 ‘This is still the best of the three options, but by a smaller margin than before.