be the average betae Suppose you won the lottery and had two options: (1) receiv

Question

be the average betae Suppose you won the lottery and had two options: (1) receiving $0.5 EXPECTED RETURNS million or (2) taking a gamble in which at the flip of a coin you receive $1 million if a head comes up but receive zero if a tail comes up 8-18 or a d. Suppose the payoff was actually $0.5 million-that was the only choice. You now face the choice of investing it in a U.S. Treasury bond that will return $537,500 at the end of a year or a common stock that has a 50-50 chance of being worthless or worth $1,150,000 at the end of the year 3. 4. Would you invest in the bond or the stock? Why? Exactly how large would the expected profit (or the expected rate of return) have to be on the stock investment to make you invest in the stock, given the 7.5 return on the bond?

Explanation / Answer

1.) The expected returns in 1st option is =$0.50 million

The expected return in Gamble is =0.50x1.00 + 0.50x0.00 =$0.50 million

Hence, he is having the similar expected returns in both cases.

2.) Payoff amount available =$0.50 million

Exepcted Returns if invested in Bond =537,500/500,000 -1 = 0.075 or 7.5%

Expected Payoff if invested in Common Stock = 0.50x0.00 + 0.50x1,150,000 =$575,000

Exepcted Returns if invested in Common Stock =575,000/500,000 -1 = 0.15 or 15.0%

3.) Since, the expected returns from stock are higher, it is wise to invest in a common stock.

4.) Let P be the expected value in common stock post investing.

0.50x0.00 + 0.50xP > 537,500

P > 537,500/0.50

P > 1,075,000

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