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Expected interest rate for the junk bond investment

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Reference no: EM131395394

This is an expected value question but I don't even know where to begin.

"Suppose you have $10,000 to invest. A broker phones you with some information you requested on certain junk bonds. If the company issuing the bonds posts a profit this year, it will pay you a 40 percent interest rate on the bond. If the company files for bankruptcy, you will lose all you invested. If the company breaks even, you will earn a 10 percent interest rate. Your broker tells you there is a 50 percent chance that they will break even and a 20 percent chance that the company will file for bankruptcy. Your other option is to invest in a risk-free government bond that will guarantee 8 percent interest for 1 year.

a. What is the expected interest rate for the junk bond investment? 

b. Which investment will you choose if your utility function is given by U = (M2) ? 

c. Which investment will you choose if your utility function is given by U = (√M) ?

Reference no: EM131395394

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