Question

Suppose that a business is considering two strategies: buy or sell. If economic conditions improve, then the strategies will return, respectively, 10% and 6%. If economic conditions condition unchanged, then the strategies will return, respectively, 1% and 2%. If economic conditions collapse, then the strategies will return, respectively, -8% and -3%. If the states of nature are equally likely, then which strategy would the business select using an expected value criterion?

Answer 1

Answer:

The answer is: Following the expected value criterion the investor should choose the sell strategy.

Explanation:

The formula we use to calculate the expected return value of the different strategies is:

            ERV = ∑ (expected return x probability of occurrence)

The buy strategy has an expected return value of of 1%

ERV Buy = (10% x 33.3%) + (1% x 33.3%) + (-8% x 33.3%) = 1%

The sell strategy has an expected return value of of 1.67%

ERV Sell = (6% x 33.3%) + (2% x 33.3%) + (-3% x 33.3%) = 1.67%