Suppose you have just inherited $10,000 and are considering the following options for investing the money to maximize your return.
1. Put the money in an interest-bearing checking account, which earns 2%. The FDIC insures the account against bank failure.
2. Invest the money in a corporate bond, which a states return of 5%, but there is a 10% chance the company could go bankrupt.
3. Loan the money to one of your friends, roommates, Mike, at an agreed-upon interest rate of 8%, but you believe that there is a 7% chance that Mike will leave town without repaying your.
4. Hold the money in cash and earn zero return.
a) If you are risk-neutral which of the four options should you choose to maximize your expected return?
b) Suppose 3 is your only option. If you could pay your friend $100 to find out extra info about Mike that would indicate with certainty if he will leave town without paying or not, would you pay the $100? What does this say about the value of better information regarding risk?
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