Karl is considering investing in a villa in Greece. It will cost him 56000 euros (€ 56000). His alternative is to invest his money, £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.
- Given that £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. [4]
In fact the £/€ 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.
- Produce a revised decision tree incorporating this information, and give appropriate advice. [3]
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 \(x^{0.5}\), and that for y in property (in thousands of euros), Karl's utility is \(y^{0.75}\).
- Repeat your computations from part (ii) using utility instead of the EMV of his investment. Does this change your advice? [3]
- 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. [2]
- 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. [4]