Transcript Document

Jen Sites
3-22
In problem 3-21 you helped Allen Young determine the best
investment strategy. Now, Young is thinking about paying for
a stock market newsletter. A friend of Young said that these
types of letter could predict very accurately whether the
market would be good, fair, or poor. Then, based on these
predictions, Allen could make better investment decisions.
A. What is the most that Allen would be willing to pay for a
newsletter?
Jen Sites 3-22
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Alternative
Market
Condition/
Good
Fair
Poor
EMV
Stock Market
1,400
800
0
880
Bank Deposit
900
900
900
900
Probabilities
of Market
Conditions
0.4
0.4
0.2
Perfect
Information
1400
900
900
Jen Sites 3-22
1100
2
EMV SOLUTION :
STOCK MARKET
$1,400 X 0.4 + 800 X 0.4 + 0 X 0.2 = $880
BANK DEPOSIT
$900 X 0.4 + 900 X 0.4 + 900 X 0.2 = $900
MAXIMUM EMV IS $900
EVI SOLUTION : expected value with perfect information - max(EMV)
= $1400 X 0.4 + 900 X 0.4 + 900 X 0.2
= $1100 - 900
= $200
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B. Young now believes that a good market will give a return of only
11% instead of 14%. Will this information change the amount that
Allen would be willing to pay for the newsletter? If you answer is yes,
determine the most that Allen would be willing to pay, given this new
information.
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Alternative
Market
Condition/
Good
Fair
Poor
EMV
Stock Market
1,100
800
0
760
Bank Deposit
900
900
900
900
Probabilities
of Market
Conditions
0.4
0.4
0.2
Perfect
Information
1100
900
900
Jen Sites 3-22
980
5
EMV SOLUTION :
STOCK MARKET
$1,100 X 0.4 + 800 X 0.4 + 0 X 0.2 = $760
BANK DEPOSIT
$900 X 0.4 + 900 X 0.4 + 900 X 0.2 = $900
EMV IS $900
EVI SOLUTION : expected value with perfect information - max(EMV)
= $1100 X 0.4 + 900 X 0.4 + 900 X 0.2
= $980 - 900
= $80
The answer is yes since EV/PI - max(EMV) is only $80.
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