Financial advisor using Decision Tree
A financial advisor has recommended two possible mutual
funds for investment: Fund A and Fund B. The return that will be achieved by
each of these depends on whether the economy is good, fair, or poor. A payoff
table has been constructed to illustrate this situation:
Investment Good
Economy Fair economy Poor Economy
Fund A $10.000 $2,000 -$5,000
Fund B $6,000 $4,000 0
Probability .2 .3 .5
a) Draw the
decision tree to represent this situation.
b) Perform
the necessary calculations to determine which of the two mutual funds is
better. Which one should you choose to maximize the expected value?
c) Suppose
there is question about the return of Fund A in a good economy. It could be
higher or lower that $ 10,000. What value for this would cause a person to be
indifferent between Fund A and Fund B (I.E., the EMV’s would be the same)?
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