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You have the chance to invest your money in either a 7.5% bond that sells at face value or an aggressive growth stock that pays only 1% dividend.
You have the chance to invest your money in either a 7.5%
bond that sells at face value or an aggressive growth stock that pays only
1% dividend. If inflation occurs, the interest rate will go up to 8%, in
which case the principal value of the bond will go down by 10%, and the
stock value will go down by 20%. If recession materializes, the interest
rate will go down to 6%. In this case, the principal value of the bond is
expected to go up by 5%, and the stock value will increase by 20%. If the
economy remains unchanged, the stock value will go up by 8%, and the
bond principal value will remain the same. Economists estimate a 20%
chance of inflation and 15% of recession. You are basing your investment
decision on next year's economic conditions.
(a) Represent the problem as a decision tree.
(b) Would you invest in stocks or bonds?