Consider the following pay off table relating to the purchase of investment deci
ID: 3004563 • Letter: C
Question
Consider the following pay off table relating to the purchase of investment decisions:
Alternatives Good Economy Poor Economy
Stocks + $70,000 - $20,000
Bonds + $50,000 + $10,000
CDs + $20,000 + $8,000
Probability 0.8 0.2
(2 points) What decision would maximize expected profits?
(2 points) What is the maximum amount that should be paid for a perfect forecast of the economy? (i.e., EVPI).
Explanation / Answer
(a)
Expected value for Stocks = 0.8*70000 -0.2*20000 = 52000
Expected value for bonds= 0.8*50000 +0.2*10000 = 42000
Expected value for CDs= 0.8*20000 +0.2*8000 = 17600
Stocks would maximise profits
(b)
EVPI = EVwPI - EVwoPI
= [0.8*70000 + 0.2*10000]- [52000] = 6000