Question

Suppose that the price of some good has increased by 30% each year for the past few years. At this point, Bob's pretty sure that the good is overpriced (the current price is $10,000, but he doesn't think it is actually worth more than $3,000). However, Bob thinks that there's a 90% chance that the price will increase by 30% this year, with a 10% chance that the price falls back to $3,000, if Bob's expectations are correct, what is the expected return (in percent terms) from investing in the good? (Be sure to include a negative sign if the number is negative.) Number If Bob is risk-neutral and could expect a 8% return if he invested in the stock market, will he invest in the good or the stock market? There's not enough information to tell O He's indifferent between investing in the two. O Hell invest in the good. O Hell invest in the stock market.

Answer 1

Return when the price rises = 30%

Return when the price falls = (3000 - 10000)/10000 x 100 = -70%

Expected return = Probability x return

Expected return = 30% x 90% + -70% x 10% = 20%

- He will invest in the good (better expected return)