Question

. Alex has the option to invest in an asset. Her financial advisor has told her there is expected value (utility) of $20,000 on the asset. With some probability p, the asset pays off well ($45,000). However, there is some chance that it will flop (1-p), and pay poorly ($2000). Assume linear utility. a. What are the probabilities that the asset will pay well and poorly? Show your calculations. We can solve this by using the expected utility/value equation: b. If she has $21000 to invest, should she invest in the asset? Why or why not?

Answer 1

Answer:

A) the probability that the asset will pay well is 51.16% and the probability that it pays poorly is 48.84%.

B) She should not invest in the asset because the expected value = the price asset, there is no expected profit.

Explanation:

There are 2 probable returns:

1. Asset will pay well = P = $45,000
2. Asset will pay poorly = 1 - P = $2,000

since the principal = $20,000, and the expected value = $20,000, the expected value equation would be:

45,000p + 2,000(1 - p) = 20,000

45,000 + 2,000 - 2,000p = 20,000

43,000p = 22,000

p = 0.5116 or 51.16%

1 - p = 48.84%