Investment and asset allocation decisions

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.

3 Magnus has been researching career possibilities. He has just completed his GCSEs, and could leave school and get a good job. He estimates, discounted at today's values and given a 49 year working life, that there is a \(50 \%\) chance of such a job giving him lifetime earnings of \(\pounds 1.5 \mathrm {~m}\), a \(30 \%\) chance of \(\pounds 1.75 \mathrm {~m}\), and a \(20 \%\) chance of \(\pounds 2 \mathrm {~m}\). Alternatively Magnus can stay on at school and take A levels. He estimates that, if he does so, there is a 75\% chance that he will achieve good results. If he does not achieve good results then he will still be able to take the same job as earlier, but he will have lost two years of his lifetime earnings. This will give a \(50 \%\) chance of lifetime earnings of \(\pounds 1.42 \mathrm {~m}\), a \(30 \%\) chance of \(\pounds 1.67 \mathrm {~m}\) and a \(20 \%\) chance of \(\pounds 1.92 \mathrm {~m}\). If Magnus achieves good A level results then he could take a better job, which should give him discounted lifetime earnings of \(\pounds 1.6 \mathrm {~m}\) with \(50 \%\) probability or \(\pounds 2 \mathrm {~m}\) with \(50 \%\) probability. Alternatively he could go to university. This would cost Magnus another 3 years of lifetime earnings and would not guarantee him a well-paid career, since graduates sometimes choose to follow less well-paid vocations. His research shows him that graduates can expect discounted lifetime earnings of \(\pounds 1 \mathrm {~m}\) with \(20 \%\) probability, \(\pounds 1.5 \mathrm {~m}\) with \(30 \%\) probability, \(\pounds 2 \mathrm {~m}\) with \(30 \%\) probability, and \(\pounds 3 \mathrm {~m}\) with \(20 \%\) probability.

1. Draw up a decision tree showing Magnus's options.
2. Using the EMV criterion, find Magnus's best course of action, and give its value. Magnus has read that money isn't everything, and that one way to reflect this is to use a utility function and then compare expected utilities. He decides to investigate the outcome of using a function in which utility is defined to be the square root of value.
3. Using the expected utility criterion, find Magnus's best course of action, and give its utility.
4. The possibility of high earnings ( \(\pounds 3 \mathrm {~m}\) ) swings Magnus's decision towards a university education. Find what value instead of \(\pounds 3 \mathrm {~m}\) would make him indifferent to choosing a university education under the EMV criterion. (Do not change the probabilities.)

2 Adrian is considering selling his house and renting a flat.
Adrian still owes \(\pounds 150000\) on his house. He has a mortgage for this, for which he has to pay \(\pounds 4800\) annual interest. If he sells he will pay off the \(\pounds 150000\) and invest the remainder of the proceeds at an interest rate of \(2.5 \%\) per annum. He will use the interest to help to pay his rent. His estate agent estimates that there is a \(30 \%\) chance that the house will sell for \(\pounds 225000\), a \(50 \%\) chance that it will sell for \(\pounds 250000\), and a \(20 \%\) chance that it will sell for \(\pounds 275000\). A flat will cost him \(\pounds 7500\) per annum to rent.

1. Draw a decision tree to help Adrian to decide whether to keep his house, or to sell it and rent a flat. Compare the EMVs of Adrian's annual outgoings, and ignore the costs of selling.
2. Would the analysis point to a different course of action if Adrian were to use a square root utility function, instead of EMVs? Adrian's circumstances change so that he has to decide now whether to sell or not in one year's time. Economic conditions might then be less favourable for the housing market, the same, or more favourable, these occurring with probabilities \(0.3,0.3\) and 0.4 respectively. The possible selling prices and their probabilities are shown in the table.

   Economic conditions and probabilities		Selling prices ( £) and probabilities
   less favourable	0.3	200000	0.2	225000	0.3	250000	0.5
   unchanged	0.3	225000	0.3	250000	0.5	275000	0.2
   more favourable	0.4	250000	0.3	300000	0.5	350000	0.2

3. Draw a decision tree to help Adrian to decide what to do. Compare the EMVs of Adrian's annual outgoings. Assume that he will still owe \(\pounds 150000\) in one year's time, and that the cost of renting and interest rates do not change.