Question: Suppose that, as an owner of a federally insured S&L in the 1980s, the price of real estate falls, and most of your loans go into default. In fact, so many loans go into default that the net worth of the S&L is negative $5 million. Federal regulators haven't realized this yet, but they will find this out soon. As a last ditch attempt to save the bank, you attract $1 million in new deposits with very generous interest rates to depositors. You have two possible investments you can make with the $1 million. You can invest in the stock market, which will pay $4 million with a probability of 0.50 and $2 million with a probability of 0.50. Alternatively, you can invest in junk bonds, which will pay off $10 million with a probability of 0.10 and 0.5 million with a probability of 0.90.
a. What is the maximum return possible from investment in the stock market?
b. What is the expected return from investment in the stock market?
c. What is the maximum return possible from investment in junk bonds?
d. What is the expected return from investment in junk bonds?
e. Based on your answers in parts a, b, c, and d, should a investor invest in stocks or junk bonds?
f. What will owners of the S&L get if it invests in stocks and gets payoff of $4 million?
g. What will owners of the S&L get if it invests in stocks and gets payoff of $2 million?
h. What will owners of the S&L get if the S&L invests in junk bonds and gets payoff of $10 million?
i. What will owners of the S&L get if the S&L invests in junk bonds and gets payoff of $0.50 million?