A young couple has $20,000 (90% of their savings) to invest in either savings bonds or a real estate deal. The (zero coupon) savings bonds return $25,000 ($5,000 interest) in three years. The (completely liquid) real estate investment, after three years, is worth $100,000 if economic conditions are good (40% chance), and worth nothing ($0) if economic conditions are bad (60%). The couple decides to invest in the savings bonds.

a. What do you know about the certainty equivalent (for the couple) of the real estate investment? HINT – Make sure you understand the concept of certainty equivalence.

b. What would you do in these circumstances?

c. Give me an example of a different set of probabilities that would change your decision in b”.