An investor may invest in a high-risk stock with a return of $1,500 if the stock

Question

An investor may invest in a high-risk stock with a return of $1,500 if the stock market goes up, $100 if the market remains the same, and -$1,000 if the market goes down. Alternatively, the investor may invest in a low-risk stock with a return of $1,000 if the market goes up, $200 if the market remains the same, and -$100 if the market goes down. Another option for the investor is to invest in a savings account and receive a fixed return. The investor does not know the probabilities that the market goes up, remains the same, and goes down. Suppose that the investor may hire a financial adviser who has "perfect" information about the stock market. What should be the return for the savings account such that the maximum amount the investor is willing to pay the financial adviser is $0?

Explanation / Answer

If investor invests in high risk stock then his total expected return looking that there is equal chance of market going up down or remaining same. = 1/3*1500+1/3*100+1/3*-1000 = 200

If investor invests in low risk stock then his total expected return looking that there is equal chance of market going up down or remaining same. = 1/3*1000+1/3*200+1/3*-100 = 366.67

Hence investment in low risk stock will end up providing more expected return to the investor.

Hence as long as he will be getting a return of 366.67 from his saving accounts, he wont be willing to pay any money to financial advisor.

Related Questions

Navigate

• Browse (All)
• Browse A
• Subjects

---

---

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