What is the certainty equivalent of the chosen investment

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Reference no: EM13151751

Suppose you have £10,000 to invest. A broker phones you with the information you requested on certain junk bonds. If the company issuing the bonds posts a profit this year, it will pay you a 40% interest rate on the bond. If the company files for bankruptcy you will lose all you invested. If the company breaks even, you will earn a 10% interest rate. Your broker tells you there is a 50% chance that they will break even and a 20% chance that the company will file for bankruptcy. Your other option is to invest in a risk-free government bond that will guarantee 8% interest for a year.

a) What is the expected interest rate for the junk bond investment?

b) What investment will you choose if your utility function were given by U(M) = M2 ? What is the certainty equivalent of the chosen investment?

c) Which investment would you choose if your utility function were given by U(M) = (M)1/2 ?

Reference no: EM13151751

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