Question

Consider an investor with $10,000 available to invest. He has the following options regarding the allocation of his available funds: (1) he can invest in a risk-free savings account with a guaranteed 3% annual rate of return; (2) he can invest in a fairly safe stock, where the possible annual rates of return are 6%, 8%, or 10%; or (3) he can invest in a more risky stock, where the possible annual rates of return are 1%, 9%, or 17%. Note that the investor can place all of his available funds in any one of these options, or he can split his $10,000 into two $5000 investments in any two of these options. The joint probability distribution of the possible return rates for the two stocks is given:

A- Use precision tree to identify the strategy that maximizes the investors expected one year earnings.

B- Perform a sensitivity analysis on the optimal decision letting the amount available to invest and the risk free return both vary, one at a time, plus or minus 100% from their base values and summarize your findings.

Use the table below:

Risky Stock return (R)

Safe Stock Return (S)

	R=1%	R=9%	R=17%
S=6%	.10	.05	.10
S=8%	.25	.05	.20
S=10%	.10	.05	.10

Answer 1