1. Fred Rubble has $8,000 to invest for one year. One option is to invest in Canada Savings Bonds that pay interest of $464 at the end of the year. Fred believes that the Canada is a financially stable country and this amount will be received regardless of what happens. Fred has also identified an investment opportunity in Abraca Ltd. Fred has evaluated information on the company and believes that there is a 40% probability that the company is strong and he will receive his investment back, plus an additional $2,000.This leaves a 60% probability that the company is weak, however, and if this is the case Fred expects he will lose $2,000, receiving only $6,000 when he sells the shares in one year. Fred is a risk-averse investor. His utility is measured as the square root of the total dollars to be received in the future.

 

Required:

2a) Explain why the use of the expected dollar returns would not be appropriate to use when evaluating which investment opportunity Fred should pursue.

4b) Calculate the expected return from each investment opportunity Fred has identified. Based on this information, should Fred invest in the Canada savings bonds or the shares in Abraca? Show your work.

3c) Fred has come to you for advice, knowing you are studying business. Make an information system that reflects that the financial statements have some value.(There are many correct answers to this and I expect students' answers will differ.)Use Bayes' Theorem and your information system to revise Fred's probabilities for whether Abraca is a strong or a weak company, given that the newly-released financial statements for Abraca show good news.

1d) Given your answer in part c) above, what is the probability that the company is weak, given the financial statements are reporting good news?

3e) Using the revised or posterior probabilities, calculate the expected returns for the Canada savings bonds and Abraca shares, and indicate whether Fred should change his decision.

Answer rating: 100% (QA)

2a The use of expected dollar returns would not be appropriate to use when evaluating which investment opportunity Fred should pursue because it does not take into account Freds risk aversion and his ... View the full answer