Mickey is considering investing some money that he inherited. The following payo

Question

Mickey 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 Mickey is considering:

GOOD

ECONOMY

POOR

ECONOMY

Bonds

Conduct sensitivity analysis and investigate the impact that a change in the probability values would have on the decision to be made between bonds and stocks.

STATE OF Nature
DECISION
ALTERNATIVE

GOOD

ECONOMY

POOR

ECONOMY

Stock Market
$110,000
-50,000

Bonds

   40,000    30,000
CDs
   43,000 43,000 Probability 0.6 0.4

Explanation / Answer

Back-up Concept

Expected Pay-off for Decision Alternative, Di, E(Di) = [j = 1, k](Pij x pj), where Pij = pay-off for Di under State of Nature j and pj = probability of State of Nature j.

Now, to work out the solution,

Let D1, D2, D3, represent Stock Market, Bonds and CDs.

Then,

E(D1) = (110000 x 0.6) + (- 50000 x 0.4) = 46000;

E(D2) = (40000 x 0.6) + (30000 x 0.4) = 36000;

E(D3) = (43000 x 0.6) + (43000 x 0.4) = 43000.

Since 46000 > 36000 and 43000, under the given probability distribution, best decision is:

D1 i.e., Stock Market ANSWER 1

To do sensitivity analysis, let probability of Good Economy be p. Then, probability of Poor Economy is (1 – p).

Then,

E(D1) = (110000p) + - 50000(1 - p) = 160000p – 50000 ……………………. (1)

E(D2) = (40000p) + 30000(1 - p) = 10000p + 30000….. ……………………. (2)

So, D1 is better than D2 so far as (2) > (1)

i.e., 160000p – 50000 > 10000p + 30000 or

150000p > 80000 or

p > 8/15.

Thus, Stock Market option is better than the Bonds option so far as probability of Good Economy is greater than 0.53 ANSWER 2

Related Questions

Navigate

• Browse (All)
• Browse M
• Subjects

---