5. Currently Lotta £ 68,000 to invest. She faces the following choice: she can b

Question

5. Currently Lotta £ 68,000 to invest. She faces the following choice: she can buy shares of AstraZeneca and Ericsson. If she invests in AstraZeneca she will lose £ 20,000 with probability 0.4, but with probability 0.4, she will win £ 35,000, while the probability is 0.2 that the value of shares remains unchanged. If she invests in Ericsson, she will lose only £ 10,000 with probability 0.5, but with probability 0.5 she will receive only £ 30,000. a. Can you tell which investment she prefers to do if she is a risk-averse person? Now suppose instead that she can split their investment and may invest 50% of her 68000 in AstraZeneca and the rest of Ericsson. The assumptions are otherwise unchanged. Which of the three investments will she choose if she is a risk-averse person? b. Can you tell which investment she prefers to do if she is a risk-neutral person? Now suppose instead that she can split their investment and may invest 50% of her 68000 in AstraZeneca and the rest of Ericsson. The assumptions are otherwise unchanged. Which of the three investments will she choose if she is a risk-neutral person?

Explanation / Answer

For Risk Neutral person:

Option 1: Full amount in Astra Zeneca

net outcome= sum of outcomes taking into account probability

= -20000*0.4 +35000*0.4 + 0*0.2

=6000

Option 2.Full amount in Ericson

Net outcome= 10000*0.5 -30000*0.5

=-10000

Option 3. 50-50% in both

Net outcome=0.5*6000-0.5*10000

-2000

He would go for Option 2

For Risk-Averse person:

He would prefer option 2

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