Alison is a nurse who happens to be very risk averse when it comes to financial

Question

Alison is a nurse who happens to be very risk averse when it comes to financial matters. She makes $45,000 per year and has just inherited $10,000 from her great aunt Sylvia, who died last week of stress-induced heart failure while playing canasta. (Sylvia was 93 when she died.) Alison is trying to decide what to do with the $10,000. After researching rates on the internet, she narrows her choices down to 2 options: a. Put the money in a Saving account with the following expected compound interest rates: Now : 2.5% 1 Year from now: 3.0% 2 Years from now : 3.5% After that: 3.5% b. Put money in Mutual Fund with the following probabilities: P(Goes Down 10% over 5 years) = 5% P(Stays the same over 5 years) = 25% P(Goes up 30% over 5 years) = 45% P(Goes up 50% over 5 years) = 25% Given Allison's strong risk-aversion, what is her best course of action and what is her risk adjusted expected value? Please use a 5 year planning horizon. You may either solve this problem by hand or use the PrecisionTree software(recommended)

Explanation / Answer

As per the question two options of putting money in Savings account or in Mutual Fund needs to be compared over a period of five years. Savings account is certain to provide the interest whereas in case of Mutual Fund gains/loss are subject to probabilities.

Under the Savings Account amount will be $11,705.29 after five years as follows:

10250 after first year, 10557.50 after second year, 10927.01 after third year, 11309.46 after fourth year and finally 11705.29 at the end of fifth year.

Under Mutual Fund the expected value after five years is 9000*.05 + 10000*.25 + 13000*.45 + 15000*.25 =$12,550

Therefore the best option is to go for Mutual Fund and the risk adjusted value (12550 vrs 11705.29)

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