Question
You would like to invest in one of the three available investment plans: money market, bonds, or stocks. The payoffs (profits) of each plan under two possible future economic conditions, PE (poor economy) and GE (good economy), are shown below. The probability of the occurrence of PE is 0.4. PE GE Money Market 2300 2700 Bonds 3100 2600 Stocks 1500 3500 In light of the expected value approach, the expected profit for the best decision alternative is a. 3000 b. 3300 c. 2700 d. 2800
Answer
Probability of poor economy PE = 0.4 and probability of good economy = 0.6
Now expected profit for all three can be calculated as below-
For money market, expected profit = (2300)(0.4)+(2700)(0.6) = 920+1620 = 2540
For bonds, expected profit = (3100)(0.4)+(2600)(0.6) = 1240+1560 = 2800
For stocks, expected profit = (1500)(0.4)+(3500)(0.6) = 600+2100 = 2700
So the best decision will be to invest in bonds and the expected profits will be 2800.
Hence the correct answer is the last option d.
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