Risk with Simple Prospects

The presence of risk means that more than one outcome is possible. A simple prospect is an investment opportunity in which a certain initial wealth is placed at risk, and there are only two possible outcomes. For the sake of simplicity, it is useful to elucidate some basic concepts using simple prospects.1

Take as an example initial wealth, W, of $100,000, and assume two possible results. With a probability p = .6, the favorable outcome will occur, leading to final wealth W1 = $150,000. Otherwise, with probability 1 - p = .4, a less favorable outcome, W2 = $80,000, will occur. We can represent the simple prospect using an event tree:

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