Suppose you have just inherited $10,000 and are considering the following options for investing the money to maximize your return:
Option 1: Put the money in an interest-bearing checking account, which earns 2%. The FDIC insures the account against bank failure.
Option 2: Invest the money in a corporate bond, with a stated return of 5%, but there is a 10% chance the company could go bankrupt.
Option 3: Loan the money to one of your friends’ roommates, Mike, at an agreed-upon interest rate of 8%, but you believe there is a 7% chance that Mike will leave town without repaying you.
Option 4: Hold the money in cash and earn zero return.
a. If you are risk-neutral (that is, neither seek out nor shy away from risk), which of the four options should you choose to maximize your expected return? (Hint: To calculate the expected return of an outcome, multiply the probability that an event will occur by the outcome of that event).
b. Suppose Option 3 is your only possibility. If you could pay your friend $100 to find out extra information about Mike that would indicate with certainty whether 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?