Problem 3-43 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:

STATE OF NATURE
GOOD FAIR POOR
INVESTMENT
ECONOMY ECONOMY ECONOMY
Fund A $ 10,000.00 $ 2,000.00 $ -5,000.00
Fund B $ 6,000.00 $ 4,000.00 $ -
Probability 20% 30% 50%

(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?
 EMV (Fund A) = (0.2)($10,000) + (0.3)($2,000) + (0.5)(-$5,000) = $100.00
EMV (Fund B) = (0.2)($6,000) + (0.3)($4,000) + (0.5)($ 0) = $2,400

Based on the EMV calculation, Fund B yields a higher EMV with an expected value of $2,400.
Hence, they should choose to invest in Fund B 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 than $10,000. What value for this would cause a person to be indifferent between Fund A
and Fund B (i.e., the EMVs would be the same)?

We can carry out a calculation:

Let Return of Fund A in a good economy = X
Indifferent between A and B:
EMV (Fund A) = EMV (Fund B)

We can carry out a calculation:

Let Return of Fund A in a good
economy = X
Indifferent between A and B:
EMV (Fund A) = EMV (Fund B)
 0.2*X + 0.3(2,000) + 0.5(-
5,000) = 2,400
0.2X = 4,300
X = $21,500
Thus, the return of Fund A in a
Good Economy should be $21,500
in order for a person to be
indifferent between Fund A and
Fund B.
0.20X + 0.30($2,000) + 0.50(-$5,000) = $2,4000
0.20X = $4,300
X = $21,500

For a person to be indifferent between Fund A and Fund B, the return of Fund A in a good
economy should be $21,500. The EMV for Fund A would not be the same as the return of Fund
A in a good economy. It could be higher or lower. As the economy rapidly changes and is
vulnerable to change, the return would not always be the same. Thus, this could be a risky
investment.