Question

7. Mr. Thaggert is trying to decide whether to invest in stocks or in CD's(Certificate of deposit). If he invests in stocks and the interest rates go up, his stock investments go down by 2%, but he gains 1% in his CD's. On the other hand if the interest rates go down, he gains 3% in his stock investments, but he loses 1% in his CD's.

1. Write a payoff matrix for Mr. Thaggert.
2. If you were his investment advisor, what strategy would you advise?

Answer 1

The payoff matrix for the given problem is:

		CD
		Interest rates go up	Interest rates go down
Stocks	Interest rates go up	-2% / +1%	-2% / -1%
	Interest rates go down	+3% / +1%	+3% / -1%

In above Payoff matrix, first return given in each quadrant is for Stocks and second return is for CD.

As, you can see clearly, that the returns in % are highest, when money invested in stocks in case of falling interest rates and invested in CD in case of rising interest rates. So, to gain highest returns Mr. Thaggert should invest in stocks in falling interest rates scenario and CD in case of rising interest rate scenario.

As an investment strategy, Mr. Thaggert should sell stocks investments, as soon as interest rates starts rising up and buying CD using the same amount. When interest rates starts falling, he should sell investments in CD and buy stocks with the sold value.