1a) Decision Tree

Let’s assume
P(G) = Probability of good returns P(G)=1
P(B) = Probability of bad returns
Good
Returns
P(B)=0

Perfect
Information
P(G)=0

Bad
Returns

P(B)=1

P(G)=.5

Good
Returns
P(B)=.5

Portfolio No
A&B Information
P(G)=.5

Bad
Returns

P(B)=.5

P(G)=.9

Good
Returns
P(B)=.1

Noisy
Information
P(G)=.2

Bad
Returns

P(B)=.8

1
2 a)

Value of Information for Portfolio A:

Perfect Information:
Good:
(90)(1) + (10)(0) = 90
Bad:
(90)(0) + (10)(1) = 10

No Information:
Good:
(90)(0.5) + (10)(0.5) = 50
Bad:
(90)(0.5) + (10)(0.5) = 50

Noisy Information:
Good:
(90)(0.9) + (10)(0.1) = 82
Bad:
(90)(0.2) + (10)(0.8) = 26

Value of Information for Portfolio B:

Perfect Information:
Good:
(20)(1) + (80)(0) = 20
Bad:
(20)(0) + (80)(1) = 80

No Information:
Good:
(20)(0.5) + (80)(0.5) = 50
Bad:
(20)(0.5) + (80)(0.5) = 50

Noisy Information:

Good:
(20)(0.9) + (80)(0.1) = 26
Bad:
(20)(0.2) + (80)(0.8) = 68
(c)
The efficient market hypothesis is satisfied in the case of perfect information for both the
portfolios since we had the highest or the lowest expected value for the returns during
good and bad events. For instance, for portfolio A we had the highest expected return
during the perfect information whereas a lowest expected value in the case of bad event
which implies that market is certain and prices reflect the true information.