A household has assets worth $2 million invested in Treasury Bonds earning 5%/year. As an alternative investment, it could purchase a parcel of non-dividend paying stock worth the same amount but which has a small chance of delivering a very high rate of return. The stock is expected to appreciate but the rate is uncertain. With 99% probability, it could appreciate by 4.8% and, with 1% probability, it could appreciate by 20%. The household has an Arrow-Pratt coefficient of relative risk aversion of R=3.0. a) Calculate the certainty equivalent income after one year under each alternative, explaining your reasoning. b) Explain what choice the household would make if the two were strict alternatives. c) Briefly discuss whether the household would be likely to choose to make either the bonds or the new stock its entire portfolio.

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