Question

Suppose that you are tryang to dectoe whether to spend $\backslash (1,000$ on stocks issued by WildWeb or on bonds issued by the same company. There is a 50 percent chance that the value of the stock will rise to $S2,200$ at the end of the year and a 50 percent chance that the stock will be worthless at the end of the year. The bonds promise an interest rate of 20 percent per year, and it is certain that the bonds and interest will be repaid at the end of the year.

a. Assuming that your time horizon is exactly one year, will you choose the stocks or the bonds?

b. By how much is your expected end-of-year wealth reduced if you make the wrong choice?

c. Suppose the odds of success improve for WildWebi Now there is a 60 percent chance that the value of the stock will be $\backslash )2,200$ at year's end and only a 40 percent chance that it will be worthless, Should you now choose the stocks or the bonds?

d. By how much did your expected end-of-year wealth rise as a result of the improved outlook for WidWeb?

Short answer

The predicted wealth increase at the end of the year is $\$120$.

Step-by-step solution

Introduction

Stocks are a type of equity in which stockholders act as the company's owners. Bonds, on the other hand, are a type of debt used to raise funds.

Explanation (Part A)

When opposed to stock investments, bond investments are less hazardous. The income generated by the bond is stable and predictable. Stocks have a 50% risk of increasing in value or decreasing in value, whereas bond investments have a guaranteed amount.

Profits are made when the value of the stock rises, but losses are made when the value of the stock falls. There will be no risk of loss if the investment is made in a bond. As a result, it is preferable to invest in bonds in order to get a specific amount in the future.

Explanation (Part B)

Calculate your bond investment and total worth at the end of the year like this:

Return on bonds $=1,000\times 20\%$

$=\$200$

Total wealth $=1,000+200$

$=\$1,200$

As a result, total bond wealth is $\$1,200$.

Calculate your stock investment and total worth at the end of the year like this:

Return on investment $=2,200\times 50\%$(Probability)

$=\$1,100$

Total wealth $=\$1,100$

As a result, the total wealth derived through investment is $\$1,100$

Calculating the expected reduction (Part B)

Calculate the predicted decrease in wealth at the end of the year if the wrong decision is made:

Expected reduction $=$Total wealth of bonds $-$Total wealth of investment

$=1,200-\$1,100$

$=\$100$

As a result, if the wrong decision is made, the predicted drop in wealth at the end of the year is$\mathbf{S}\mathbf{100}$

Explanation (Part c)

Stock investing is a high-risk investment, and stock investment is not required. Stocks have a 60% probability of increasing in value and a 40% possibility of decreasing in value, while bond investments have a guaranteed sum of $\$1,200$.

Calculate the predicted increase in wealth at the conclusion of the year like this:

Expected wealth rise $=\left[2,200\times \left(\frac{60}{100}\right)\right]+\left[0\times \left(\frac{40}{100}\right)\right]$

$=1,320+0$

$=1,320$

It is better to invest in stocks rather than bonds because bonds currently yield $1200 while stocks yield $1320.

Explanation (Part D)

The predicted increase can be computed using the following formula:

Expected increment $=$Total wealth of investment $-$Total wealth of bonds

$=1,320-1,200$

$=\$120$

As a result, the predicted wealth increase at the end of the year is $\$120$.