Bill’s entire wealth consists of the money in his bank account: $12,000. Bill’s

Question

Bill’s entire wealth consists of the money in his bank account: $12,000. Bill’s friend Bob claims to have discovered a great investment opportunity, which would require an investment of $10,000. Bob does not have any money and asks Bill to provide the $10,000. According to Bob the investment could yield a return of $150,000, in which case Bob will return the $10,000 to Bill and then give him 50% of the remaining $140,000. According to Bob the probability that the investment will be successful is 12%; The probability that the initial investment of $10,000 will be completely lost is 88%. Bill decides to go ahead with the investment and gives $10,000 to Bob. What is Bill’s attitude to risk?

Explanation / Answer

Bill is risk loving

See that if Bill accepts the deal, he will have $12000 + $70000 = $82000 for a successful investment and $2000 for unsuccessful investment. Expected profit / payoff = 82000 x 12% + 2000 x 88% = $11,600

Now if he does not invest, he gets $12000. Since he is preferring an event with lower expected value than a higher certain income, he must be risk seeking.

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