This Question: 1 pt 2of50(1 complete) This Test: 50 pts possible Suppose that yo
ID: 1144417 • Letter: T
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This Question: 1 pt 2of50(1 complete) This Test: 50 pts possible Suppose that you are trying to decide whether to spend $1,000 on stock issued by WildWeb or on a bond issued by the same company. There is a 50 percent chance that the value of the stock will rise to $2.200 at the end of the year and a 50 percent chance that the stock will be worthless at the end of the year. The bond promises an interest rate of 20 percent per year, and k is certain that the bond and interest will be repaid at the end of the year Assuming that your time horizon is exactly one year, wil you choose the stock or the bond? L By how Suppose the odds of success improve for WidWeb: Now there is a 60 much is your expected end-of-year wealth reduced if you make the wrong choice? Should percent chance that the value of the stock will be $2.200 at year's end and only a 40 you now choose the stock or the bond?Explanation / Answer
Initial wealth = $1000
Probability of value of stock going up = 0.5
Probability that stock will be worthless = 0.5
So, the expected value of wealth if money is invested in the stock is given by =
0.5(2200) + 0.5(0) = 1100
Interest rate on bond = 20%p.a
Total wealth at the end of year when money is invested in bonds = 1000 + 0.2(1000) = 1200
Since the value of investing money in bonds is greater than ($1200) expected value of money invested in stock ($1100). Hence, rationally a consumer should prefer bond over stock to invest $1000.
The expected weath from investing in stock = $1100
The wealth if the stock becomes worthless = $0
So, the fall in wealth = $1100
The new expected value of money in stock market =
0.6 (2200) + 0.4(0) = 1320
The wealth at the end of year from investing in bond is still the same i.e. $1200
So, since the expected wealth from investing in the stock market is greater than investing in bond, a rational consumer should invest in stock.
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