You are an expert on financial statement analysis and the quality of financial reporting, with extensive experience in rational investing. You determine that the current quality of financial reporting is summarized in the following information system: The states of nature refer to future performance of CG Ltd., of which you are a shareholder. GN (good news) and BN (bad news) summarize the information content of current financial statements. CG Ltd. has just released its quarterly financial report. You analyze this report, and decide that it shows GN. Your decision problem is to sell your shares now (a1) or hold them for another quarter (a2).

Your prior probability of the high state is 0.7. The current market value of your CG Ltd. shares is $ 81. If CG is in the high state, you are sure that your shares will be worth $ 100 if you sell at the end of the next quarter. If CG is in the low state, you are sure that your shares will then be worth $ 36. You are risk averse, with utility equal to the square root of your sale proceeds.

a. What information is included in your prior probabilities? Are they subjective or objective? Why?
b. Are the information system probabilities subjective or objective? What determines these probabilities?
c. Should you sell or hold your CG shares? Showcalculations.

  • CreatedSeptember 09, 2014
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