An investor is considering three strategies for an investment. The probable retu

Question

An investor is considering three strategies for an investment. The probable returns are estimated as follows: Strategy 1 : A profit of $ 10,000 with probability 0.15 and a loss of $ 1,000 with probability 0.85 Strategy 2 : A profit of $1,000 with probability 0.5, a profit of $500 with probability 0.3, and a loss of $500 with probability 0.2 Strategy 3: A certain profit of $400 Which strategy has the highest expected profit and how much is it? Strategy 1 gives the highest expected profit of $550. Strategy 1 gives the highest expected profit of $650. Strategy 3 gives the highest expected profit of $400. Strategy 2 gives the highest expected profit of $550.Strategy 2 gives the highest expected profit of $700.

Explanation / Answer

Strategy-1 :

It gives the profit of $10000 with probability 0.85 and a loss of $1,000(i.e a profit of -$1,000) with a probability 0.85.

By the definition of expectation, expected profit of strategy-1 = $10,000*0.15 + (-$1,000)*0.85 = $1,500 - $850 =$650 ...................................................(1)

Strategy-2 :

By same logic as above expected profit of strategy-2 = $1,000*0.5 + $500*0.3 + (-$500)*0.2

= $500 + $50 = $550 ......................................(2)

Strategy-3 :

It gives a ceratin profit of $400 .......................................(3)

By (1), (2), (3), We see that the expected profit of strategy-1 is maximum and it is worth $650.

So the answer is (b)

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