Question

Daddy Warbucks, a very wealthy investor, built his fortune through his legendary investing knowledge. At present, he has been offered three investments from which he would like to choose one.

The first is a conservative investment that would perform quite well in an expanding economy and only suffer a small loss in a worsening economy. The second is a speculative investment that would perform extremely well in an expanding economy, but do quite poorly in a worsening economy. The last alternative is a countercyclical investment that would suffer some loss in an expanding economy, but perform well in a worsening economy.

Warbucks believes that there are three possible scenarios during the lives of these investments as follows:

· An Expanding Economy

· A Stable Economy

· A Worsening Economy

He is somewhat pessimistic about where the economy is headed, and so has assigned probabilities of 0.1, 0.5, and 0.4 respectively to these three scenarios. He also estimates that his profits under these respective scenarios are shown in the following payoff table.

	Expanding Economy	Stable Economy	Worsening Economy
Conservative Investment	$30 Million	$5 Million	$-10 Million
Speculative Investment	$40 Million	$10 Million	$-30 Million
Countercyclical Investment	$-10 Million	$0	$15 Million
Probability	0.1	0.5	0.4

1. Considering this data, which investment should he make based on an Expected Monetary Value (EMV) criterion?

2. Upon reflection, Daddy Warbucks doesn't have a great deal of confidence in the accuracy of his probability estimates. Which investment should he make under each of the following criteria?

a) Maximax

b) Maximin

c) Realism Criterion with indices of 0.25, 0.65, and 0.85

d) Equally Likely States of Nature e) Minimax Regret

3. Briefly describe how Warbucks might leverage Bayes' Theorem (Bayes' Decision Rule) to improve his confidence about his probability estimates if he believes that the 10% estimate for an expanding economy is accurate, but is unsure about the odds of the other two scenarios.

Answer 1