2 Karl is considering investing in a villa in Greece. It will cost him 56000 euros ( € 56000 ). His alternative is to invest his money, \(\pounds 35000\), in the United Kingdom. He is concerned with what will happen over the next 5 years. He estimates that there is a \(60 \%\) chance that a house currently worth \(€ 56000\) will appreciate to be worth \(€ 75000\) in that time, but that there is a \(40 \%\) chance that it will be worth only \(€ 55000\). If he invests in the United Kingdom then there is a \(50 \%\) chance that there will be \(20 \%\) growth over the 5 years, and a \(50 \%\) chance that there will be \(10 \%\) growth.

1. Given that \(\pounds 1\) is worth \(€ 1.60\), draw a decision tree for Karl, and advise him what to do, using the EMV of his investment (in thousands of euros) as his criterion. In fact the \(\pounds / €\) exchange rate is not fixed. It is estimated that at the end of 5 years, if there has been \(20 \%\) growth in the UK then there is a \(70 \%\) chance that the exchange rate will stand at 1.70 euros per pound, and a \(30 \%\) chance that it will be 1.50 . If growth has been \(10 \%\) then there is a \(40 \%\) chance that the exchange rate will stand at 1.70 and a \(60 \%\) chance that it will be 1.50 .
2. Produce a revised decision tree incorporating this information, and give appropriate advice. A financial analyst asks Karl a number of questions to determine his utility function. He estimates that for \(x\) in cash (in thousands of euros) Karl's utility is \(x ^ { 0.8 }\), and that for \(y\) in property (in thousands of euros), Karl's utility is \(y ^ { 0.75 }\).
3. Repeat your computations from part (ii) using utility instead of the EMV of his investment. Does this change your advice?
4. Using EMVs, find the exchange rate (number of euros per pound) which will make Karl indifferent between investing in the UK and investing in a villa in Greece.
5. Show that, using Karl's utility function, the exchange rate would have to drop to 1.277 euros per pound to make Karl indifferent between investing in the UK and investing in a villa in Greece.