The president of the United States is considering two different candidates to ch

Question

The president of the United States is considering two different candidates to chair the Federal Reserve. If he chooses Alan, the probability that inflation will be 2 percent is 0.4 and the probability that inflation will be 4 percent is 0.6. If the president chooses Ben, the probability that inflation will be 2 percent is 0.6 and the probability that inflation will be 3 percent is 0.4. If you are an investor with your funds invested in bonds paying 7 percent, calculate the standard deviation of your real return if Alan is chosen to chair the Fed and if Ben is chosen to chair the Fed. Which candidate would you prefer? Explain why. Show calcuations.

Explanation / Answer

mean of Alan=0.02*0.4 + 0.04*0.6=0.032

Variance of Alan=(0.02 -0.032)^2*0.4 + (0.04 -0.032)^2*0.6=0.011328

So sd of Alan=0.10643

mean o f Ben=0.02*0.6 + 0.03*0.4=0.024

variance of Ben=(0.02- 0.024)^2*0.6 + (0.03- 0.024)^2*0.4=0.000024

So sd of Ben=0.0049

Since sd of Ben is much smaller than Alan, I prefer Ben

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