Question

Suppose that you are rying to decide whether to spend $1,000 on stock issued by WildWeb or on a bond issued by the same company. There is a 60 percent chance that the value of the stock will rise to $2,200 at the end of the year and a 40 percent chance that the stock will be worthless at the end of the year. The bond promises an interest rate of 20 percent per year, and it is certain that the bond and interest will be repaid at the end of the year. Assuming that your time horizon is exactly one year, will you choose the stock or the bond? stock By how much is your expected end-of-year wealth reduced if you make the wrong choice?

Answer 1

A. The price of the stock of Wildweb is $1,000 and we can invest the same amount in bond too.

1. If we purchase bond

At the end of one year, we will receive $1,200 (Face value of bond $1,000 and interest $200)

2. If we purchase stock

There is 60% chances that the stock will rise to $2,200 at the end of one year and 40% chance that it will be worthless. So the average value of the stock will be $1,320 ($2,200*0.60 + $0*0.40).

Considering the above, we will choose the stock.

B. So considering the choice of stock is correct, I will receive $2,200 at the end of one year. We are considering the value of stock at $2,200 because there are only 2 probabilities that either the value of stock will be $2,200 or zero and if we are correct in our choice of stock then it mean that the stock price will go to $2,200.

So, here if i make the wrong choice my year end wealth will be reduced by $1,000 (Stock value $2,200 - Bond Value $1,200).