Suppose you have two options for investing $10,000. Over a 5-year period, invest

Question

Suppose you have two options for investing $10,000. Over a 5-year period, investment A will yield a guaranteed return of 20%. Over a 5-year period investment B could result in a total loss of your investment with probability 1/2, a 100% return with probability 1/4, or a 200% return with probability 1/4. Which of the following statements is definitely correct? If you prefer investment B to investment A then you are risk-loving and your risk premium in this situation is at least $500. If you prefer investment B to investment A then you are risk neutral. If you prefer investment B to investment A then you are risk averse and your risk premium in this situation is at least $500. If you are indifferent between investments A and B, then you are risk averse and your risk premium in this situation is $500.

Explanation / Answer

If you prefer investment B to investment A then you risk averse and your risk premium in this situation is at least $500.

Profit for plan A

20%of 10000 = 10000*(20/100) = $500

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