Suppose you have a mutually exclusive investment choice to make: you can choose

Question

Suppose you have a mutually exclusive investment choice to make: you can choose A or B. If you choose to invest in A, your income, m, will be 5 with certainty. If you choose B, you may end up earning m-400, but there is only a 1% chance of this event. Otherwise, given that you choose B, you will earn 2. Suppose your value of whatever income actually occurs from your investment choice is given by In where m represents the (expected) income from the chosen asset. This implies that the expected value (or utility) of the income from investment choice "" is given by EU i-1 where p is the probability of event j, and K is the number of possible outcomes Naturally, 1 (a) Given the above information, what is the rational choice, asset A or B? Explain. (b) Suppose that you can hire a financial analyst that guarantees to be able to forecast the outcome of B with certainty. After voicing your skepticism of a forecast under certainty, the analyst offers you a binding contract to offset any losses that would be incurred if the forecast were incorrect. Based on the above information, what is the maximum you would rationally pay for this information? Explain.

Explanation / Answer

a. So as per information the rational choice we have to choose is Asset A because it will help them to generate more profit as compared with the B.

b. The maximum will rationally pay for this information is 3 not because of Asset A has 5 and B has 2 but because of the parameters i.e. the forecast and the certainity factors.

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