A financial advisor has recommended two possible mutual funds for investment: Fu

Question

A financial advisor has recommended two possible mutual funds for investment: Fund A and Fund B. The return that will be achieved by each of these depends on whether the economy is good, fair, or poor. A payoff table has been constructed to illustrate this situation:
Investment
Good Economy
Fair Economy
Poor Economy
Fund A
$ 10,000
$ 2,000
$ - 5,000
Fund B
$ 6,000
$ 4,000
0
Probability
0.2
0.3
0.5
(b) Perform the necessary calculations to determine which of the two mutual funds is better. Which one should you choose to maximize the expected value?
(c) Suppose there is question about the return of Fund A in a good economy. It could be higher or lower than $10,000. What value for this would cause a person to be indifferent between Fund A and Fund B (i.e., the EMVs would be the same)?

Explanation / Answer

(b) Perform the necessary calculations to determine which of the two mutual funds is better. Which one should you choose to maximize the expected value?

EMV(A) = (10000)*(0.2)+(2000)*(0.3)+(-5000)*(0.5)

= $100

EMV(B)= (6000)*(0.2)+(4000)*(0.3)+(0)*(0.5)

=$2400

So Fund B is a good decision

(c) Suppose there is question about the return of Fund A in a good economy. It could be higher or lower than $10,000. What value for this would cause a person to be indifferent between Fund A and Fund B (i.e., the EMVs would be the same)?

2400 = (X)*(0.2)+(2000)*(0.3)+(-5000)*(0.5)

2400=(X)*(0.2)-1900 (X)(0.2)=4300

X=21500

The value that cause fund A to be indifferent is $21500

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