3. Consider three alternative bonds that you might invest in, each of which matu

Question

3. Consider three alternative bonds that you might invest in, each of which matures in one year. The following table shows the probability that you will receive each possible return. For example, if you buy bond A, the probability is 90 percent that your return will be 20 percent and the probability is 10 percent that your return will be 100 percent (in other words, you lose the entire amount invested). Bond Probability Return Bond A 90% 20% 10% -100% Bond B 75% 40% 25% -40% Bond C 60% 10% 40% -10% a. Calculate the expected return for all three bonds in percentage terms. Show all your work. In your calculations, you may round after two significant digits. b. Calculate the standard deviations of the returns on these bonds. Show all your work. If you are extremely risk averse, which of the three bonds would you buy? Why? c. Would a risk-averse investor ever buy Bond A instead of one of the other bonds? Why or why not?

Explanation / Answer

Bond P1 P2 P3 P4 Mean P SD Bond-A 90 20 10 -100 5 78.53 Bond-B 75 40 25 -40 25 48.13 Bond-C 60 10 40 -10 25 31.09 P represents the probability b>If I am risk averse , I will buy Bond-C as the mean is high and SD is low. c>Yes a risk averse person may buy A as the SD is high and it may make the P very high in one direction.

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