Shir Khan is considering investing some money that he inherited. The following p
ID: 3125627 • Letter: S
Question
Shir Khan is considering investing some money that he inherited. The following payoff table gives the profits that would be realized during the next year for each of three investment alternatives Shir is considering
State of Nature
State of Nature
Decision Alternative
Good Economy
Poor Economy
Stock Market
What decision would maximize expected profits?
What is the maximum amount that should be paid for a perfect forecast of the economy?
State of Nature
State of Nature
Decision Alternative
Good Economy
Poor Economy
Stock Market
80,000 -20,000 Bonds 30,000 20,000 CDs 23,000 23,000 Probability 0.5 0.5Explanation / Answer
Shir Khan can invest in one of the following:-
1. Stock Market
2. Bonds
3. CDs
The probability of having a good economy is .5 and bad economy is also .5
Case I (Invest in Stock market)
The expected market value (EMV) is 80000*.5-20000*5= 30000
Case II (Invest in Bonds)
The expected market value is 30000*.5+20000*.5=25000
Case III (Invest in CDs)
The expected market value is 23000*.5+23000*.5=23000
The maximum expected profit is obtained if Shira Khan invests in Stocks (Ans i)
The next questions asks about what should be paid for the "Perfect Forecast". This means we would be buying information and in doing so we have to ensure that we don't make more loss than the maximum expected market value in case of absence of perfect information.
Now the perfect information may state the economy will be "Good". So in that case it makes sense for Shira to invest in Stock Market, as it provides maximum return.
The perfect information may state that the econpmy would be "Bad" and in that case Shira would invest in CDs,as it provides maximum return.
So the expected payout for Shira would be 80000*.5 + 23000*.5= 51500
As Shira was having a maximum payout of 30000 in the previous case (Without perfect forecast) he can afford to pay that amount for this extra information which will help him making a better choice. Hence, the money that can be paid for perfect information is 51500-30000=Rs. 21,500 (Ans ii)
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