Essay Problem
I. Both Nadia and Samantha are applying to insure their car against theft. Nadia lives in a secure neighborhood, where the probability of theft is 10%. Samantha lives in a lesser secure neighborhood where the probability of theft is 25%. Both Nadia and Samantha own cars worth $10,000, and are willing to pay $100 over expected loss for insurance. Suppose the insurance company cannot tell them apart but expects them to be different values and charges them an average premium of $1850. How much profit would it make?
i. 1850
ii. Zero-they would break even
iii. They would make a loss of $650
iv. They would make a loss of $1100
II. Relative to a manager of a company owned store, a franchisee is more likely to
i. Work very hard
ii. Not work as hard
iii. Work only evenings
iv. Work only night shifts
III. 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 shortly. 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 probability 0.5 and $2 million with probability 0.5. Alternatively, you can invest in junk bonds, which pay off $10 million with probability 0.1 and $0.5 million with probability 0.9.
i. Which investment has the highest expected value to ordinary investor?
ii. Which investment has the highest expected value to S&L owner? [Hint: Federal deposit insurance limits an S&L's losses to zero.]
The response must include a reference list. Using Times New Roman 12 pnt font, double-space, one-inch margins, and APA style of writing and citations.