Answer The Following 3 Questions: 2 Multiple Choices And 1 E

Answer The Following 3 Questions 2 Multiple Choices And 1 Essay Ques

Answer The Following 3 Questions 2 Multiple Choices And 1 Essay Ques

Answer the following 3 questions. (2 multiple choice and 1 essay question) For the multiple choice questions, you need to EXPLAIN YOUR ANSWER IN WORDS. For the essay question, no words limited, just fully answer it should be good, I need it in 10 hours.

Paper For Above instruction

Question 1: 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?

Answer: The insurance company's expected loss from Nadia is calculated as: expected loss = probability of theft × value of the car = 10% × $10,000 = $1,000. Nadia is willing to pay $100 over this, so her total premium valuation is $1,100. Similarly, for Samantha, expected loss = 25% × $10,000 = $2,500, and she is willing to pay $100 over, totaling $2,600.

However, the company charges an average premium of $1,850 regardless of each individual’s risk profile. The profit is calculated based on the difference between the premium received and the expected loss.

Considering the mix of clients, if the company insures both at the average premium, the expected loss per person varies. If we assume an equal number of Nadia and Samantha clients, then the company's expected total premium income per client is $1,850, and total expected losses are the average of the individual expected losses: ($1,000 + $2,500)/2 = $1,750.

Hence, profit per client = premium - expected loss = $1,850 - $1,750 = $100. If both clients are insured, total profit from one Nadia and one Samantha is $200.

But if we look at the overall profitability considering the different probabilities and premiums, the company's expected profit per client is minimal, close to breakeven or slight profit. Since the premium charged surpasses the expected loss on average, the company would likely make a profit, roughly around $100 per client, leading to a total profit if many clients are insured.

Therefore, the closest correct answer based on the options provided is:

  • Answer: B. Zero-they would break even

Question 2:

Relative to a manager of a company owned store, a franchisee is more likely to

  • A. Work very hard
  • B. Not work as hard
  • C. Work only evenings
  • D. Work only night shifts

Answer: The most appropriate answer is B. Not work as hard. Franchisees typically operate with some degree of independence and often face different incentives than managers employed directly by the parent company. They might be less motivated to exert high effort, especially if their monitoring or oversight is limited, leading to less effort compared to a direct employee or a manager, who has their performance more directly linked to their compensation and evaluation.

Question 3:

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.

(a) Which investment has the highest expected value to an ordinary investor?

(b) Which investment has the highest expected value to the S&L owner, considering deposit insurance limits that cap losses?

Answer:

(a) Expected value for an ordinary investor:

The stock market investment has an expected value calculated as:

  • EV_stock = (0.5 × $4 million) + (0.5 × $2 million) = $2 million + $1 million = $3 million

The junk bonds investment has an expected value of:

  • EV_junk_bonds = (0.1 × $10 million) + (0.9 × $0.5 million) = $1 million + $0.45 million = $1.45 million

Hence, the stock market investment has the higher expected value for an ordinary investor: $3 million vs. $1.45 million.

(b) Expected value for the S&L owner:

Considering federal deposit insurance which limits losses to zero, the S&L owner faces different incentives. For the stock market, the worst possible outcome is a loss of the initial $1 million deposit, but the expected return is higher. Since the bank's liabilities are insured, the owner's risk is limited; losses beyond the insured limit do not affect the bank's net worth.

In the case of the junk bonds, despite a higher potential payoff, the low probability (10%) of the $10 million payoff and high probability (90%) of only $0.5 million make it less predictable. But considering deposit insurance limits, the worst-case scenario is that the bank only loses the deposited amount, and the potential high payoffs still make this investment more attractive from an expected value perspective of the bank's owner.

Therefore, the highest expected value to the S&L owner, considering insurance protection against losses, is the stock market investment with an expected value of $3 million, as it provides high upside potential with limited downside risk due to insurance coverage.

References

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