Suppose that as an owner of a federally insured S&L in the 1980s the price of re

Question

Suppose that as an owner of a federally insured S&L in the 1980s the price of real estate falls, and most of your loans go into default. In fact, so many loans go into default that the net worth of the S&L is a negative($5 million). Federal regulators haven't realized this yet, but they will shortly. As a a last-ditch attempt to save the bank, you attract $1 million in new deposits w/very generous interest rates to depositors. You have 2 possible investments you can make w/the $1 million. You can invest in stock market, which will pay $4 million w/probability 0.5 and $2 million w/probability 0.5. Alternatively, you can invest in junk bonds, which pay off $10 million w/probability 0.1 and $0.5 million w/probability 0.9.
a. Which investment has the highest expected value to an ordinary investor? Show your calculations.
b. Which investment has the highest expected value to you, the S&L owner? Show your claculations.

Explanation / Answer

a. for possibility 1 e(X)=.5(4 million)+.5(2 million) = 3 million for possibility 2 e(x)=.1(10 million)+.9(.5 million)=1.45 million ordinary investors choose 1st one

Related Questions

Navigate

• Browse (All)
• Browse S
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.