Suppose you have €100.000 to invest. A broker phones you with

some information you

requested on junk bonds. If the company issuing the bonds posts a

profit this year, it will

pay you a 50% interest rate. If the company files for bankruptcy,

you will lose all you invested.

If the company breaks even, you will earn an 8% interest rate. Your

broker tells you that there

is a 40% chance that they will break even, and a 15% chance that

the company will file for

bankruptcy. Your alternative option is to invest in a risk-free

government bond that will

guarantee a 7% interest for one year.

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

investment?

b) What is the variance of the interest rate of the junk bond

investment?

c) Which investment will you choose if your utility is given by

U(x)=x²?

d) Which investment will you choose if your utility is given by

U(x)=x0.5?

some information you

requested on junk bonds. If the company issuing the bonds posts a

profit this year, it will

pay you a 50% interest rate. If the company files for bankruptcy,

you will lose all you invested.

If the company breaks even, you will earn an 8% interest rate. Your

broker tells you that there

is a 40% chance that they will break even, and a 15% chance that

the company will file for

bankruptcy. Your alternative option is to invest in a risk-free

government bond that will

guarantee a 7% interest for one year.

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

investment?

b) What is the variance of the interest rate of the junk bond

investment?

c) Which investment will you choose if your utility is given by

U(x)=x²?

d) Which investment will you choose if your utility is given by

U(x)=x0.5?