Question

An investor has to choose between stocks A&B, each selling for $10. Stock A, can either increase in price to $12, with a 50% probability or stay at $10 with a 50% probability. Stock B can either increase in price to $15 with a 50% probability or go down to $7 with a 50% probability. Which of the stocks would the investor choose​ a. ​None of the stocks b. ​The investor would exit the market c. ​Stock A d. ​Stock B

Answer 1

Answer:

c. ​Stock A

Explanation:

The future expected value of each stock is given by the sum of each possible outcome multiplied by its correspondent likelihood.

For Stock A, the expected value is:

$E(A) = \ 12*0.5+\ 10*0.5\\E(A) =\ 11$

For Stock B, the expected value is:

$E(B) = \ 15*0.5+\ 7*0.5\\E(B) =\ 11$

Both stocks have the same expected value, so it would be reasonable to assume that the investor could pick any of the two options. However, since A has a lower associated risk (Worst case scenario is better than stock B), the investor should choose stock A.