Question

Suppose you have just inherited $10,000 and are considering options for investing the money to maximize your return. If you are risk-neutral (that is, neither seek out nor shy away from risk), which of the following options should you choose to maximize your expected return? (Hint: To calculate the expected return of an outcome, multiply the probability that an event will occur by the outcome of that event and then add them up.) A. Hold the money in cash and earn zero return. O B. Put the money in an interest-bearing chequing account that earns 3%. The CDIC insures the account against bank failure. O C. Loan the money to one of your friend's roommates, Mike, at an agreed-upon interest rate of 7% even though you believe there is a 6% chance that Mike will leave town without repaying you. OD. Invest the money in a corporate bond with a stated return of 5% although there is a 9% chance the company could go bankrupt. Suppose you are risk-neutral and have only two choices for how to invest your money. The first option is to loan the money to one of your friend's roommates, Mike, at an agreed-upon interest rate of 7% even though you believe there is a 6% chance that Mike will leave town without repaying you. The second option is to hold the money in cash and earn zero return. If you could pay your friend $50 to find out extra information about Mike that would indicate with certainty whether he will leave town without paying, you would pay the $50. Assuming that you always choose the best option based on the information available to you, your expected return if you pay your friend (accounting for the cost of paying your friend) is $, which is your expected return if you do not pay your friend. (Round your response to the nearest cent.) What does this say about the value of better information regarding risk? O A. A problem created by asymmetric information can't be solved with money. OB. Paying a small amount to improve risk assessment can be very beneficial. O C. Paying a small amount to get better information regarding risk doesn't bring benefits. OD. Paying a small amount of money is inefficient in cases of moral hazard.

Answer 1

Solution-

As given in the first case we have to choose the best option which will yield the maximum return.

As investors is risk neutral I.e neutral the best option is C.loan the money to friend on agreed interest rate of 7% even though there is chance of 6% that he may not repay you but as risk neutral investor this option gives maximum return.

In second scenario, the correct option after studying the case seems to be paying small amount to improve risk is helpful

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