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Allen Young is considering paying for a stock market newsletter that claims to accurately predict the market. Based on the information provided: - The maximum Allen would be willing to pay for the newsletter is $200, as that is the difference between the expected value with the newsletter's perfect predictions ($1100) and the highest expected monetary value without it ($900) from investing in bank deposits. - If a good market return is now only 11% instead of 14%, the difference between perfect predictions and bank deposits is only $80. So with this new information, the maximum Allen would be willing to pay for the newsletter is $80.
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Here are the steps to solve this example:
1) Set up the production run model equations:
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TRAINING
- 1. 1 In problem 3-21 you helped Allen Young determine the best investment strategy. Now, Young is thinking about paying for a stock market newsletter. A friend of Young said that these types of letter could predict very accurately whether the market would be good, fair, or poor. Then, based on these predictions, Allen could make better investment decisions. A. What is the most that Allen would be willing to pay for a newsletter?
- 2. 2 Alternative Market Condition/ Good Fair Poor EMV Stock Market 1,400 800 0 880 Bank Deposit 900 900 900 900 Probabilities of Market Conditions 0.4 0.4 0.2 Perfect Information 1400 900 900 1100
- 3. 3 EMV SOLUTION : STOCK MARKET $1,400 X 0.4 + 800 X 0.4 + 0 X 0.2 = $880 BANK DEPOSIT $900 X 0.4 + 900 X 0.4 + 900 X 0.2 = $900 MAXIMUM EMV IS $900 EVI SOLUTION : expected value with perfect information - max(EMV) = $1400 X 0.4 + 900 X 0.4 + 900 X 0.2 = $1100 - 900 = $200
- 4. 4 B. Young now believes that a good market will give a return of only 11% instead of 14%. Will this information change the amount that Allen would be willing to pay for the newsletter? If you answer is yes, determine the most that Allen would be willing to pay, given this new information.
- 5. 5 Alternative Market Condition/ Good Fair Poor EMV Stock Market 1,100 800 0 760 Bank Deposit 900 900 900 900 Probabilities of Market Conditions 0.4 0.4 0.2 Perfect Information 1100 900 900 980
- 6. Jen Sites 3-22 6 EMV SOLUTION : STOCK MARKET $1,100 X 0.4 + 800 X 0.4 + 0 X 0.2 = $760 BANK DEPOSIT $900 X 0.4 + 900 X 0.4 + 900 X 0.2 = $900 EMV IS $900 EVI SOLUTION : expected value with perfect information - max(EMV) = $1100 X 0.4 + 900 X 0.4 + 900 X 0.2 = $980 - 900 = $80 The answer is yes since EV/PI - max(EMV) is only $80.
- 7. Jen Sites 3-22 6 EMV SOLUTION : STOCK MARKET $1,100 X 0.4 + 800 X 0.4 + 0 X 0.2 = $760 BANK DEPOSIT $900 X 0.4 + 900 X 0.4 + 900 X 0.2 = $900 EMV IS $900 EVI SOLUTION : expected value with perfect information - max(EMV) = $1100 X 0.4 + 900 X 0.4 + 900 X 0.2 = $980 - 900 = $80 The answer is yes since EV/PI - max(EMV) is only $80.