A young couple has $24,000 (90% of their savings) to invest in either savings bo
ID: 2807310 • Letter: A
Question
A young couple has $24,000 (90% of their savings) to invest in either savings bonds or a real estate deal. The (zero coupon) savings bonds return $30,000 ($6,000 interest) in three years. The (completely liquid) real estate investment, after three years, is worth $60,000 if economic conditions are good (60% chance), and worth nothing ($0) if economic conditions are bad (40%). The couple decides to invest in the savings bonds.
1. What do you know about the certainty equivalent (for the couple) of the real estate investment? HINT – Make sure you understand the concept of certainty equivalence.
2. What would you do in these circumstances?
3. Give me an example of a different set of probabilities that would change your decision in b”.
A young couple has $24,000 (90% of their savings) to invest in either savings bonds or a real estate deal. The (zero coupon) savings bonds return $30,000 (S6,000 interest) in three years. The (completely liquid) real estate investment, after three years, is worth $60,000 if economic conditions are good (60% chance), and worth nothing (SO) if economic conditions are bad (40%). The couple decides to invest in the savings bonds. 2. What do you know about the certainty equivalent (for the couple) of the real estate investment? HINT-Make sure you understand the concept of certainty equivalence. What would you do in these circumstances? Give me an example of a different set of probabilities that would change your decision in b" a. b. c.Explanation / Answer
Savings Bonds:
Return on savings bond - $6000 (in 3 years)
Total savings - $30000
Ans a) For real estate:
Probability of good economic conditions : 0.6 ; expected return : $60000
Probability of good economic conditions : 0.4 ; expected return : $0
Certain equivalence of real estate investment : 0.6 * 60000 + 0.4*0
= $36000
(b) I would do the same as done by the couple. Though the certain equivalence of Real estate is more than the savings bonds return (just 20% more), but if the economic conditions go bad, I would lose all of my savings. Theoretically real estate is a better option , but practically savings bonds are.
(c) If the economic conditions to be good probability is 0.9, that would cause certain equivalence to be $54000 which is 1.8 times the value of sabvings bonds. So it is worth the risk her as my investment almost doubles.
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