Question

You recently purchased a stock that is expected to earn 20 percent in a booming economy, 11 percent in a normal economy, and lose 28 percent in a recessionary economy. There is a 5 percent probability of a boom and a 75 percent chance of a normal economy. What is your expected rate of return on this stock? Select the choice that is closest to your answer.

a) -2.25 percent
b) 1.15 percent
c) 2.60 percent
d) 3.65 percent

Answer 1

The expected rate of return on the stock is 3.65 percent.

To calculate the expected rate of return on the stock, we need to multiply each possible return by its corresponding probability, and then sum the results.

The expected rate of return can be calculated as follows:

1. 20% return in a booming economy with a 5% probability: 20% * 0.05 = 1%
2. 11% return in a normal economy with a 75% probability: 11% * 0.75 = 8.25%
3. -28% return in a recessionary economy with a 20% probability: -28% * 0.20 = -5.6%

Finally, we sum the results: 1% + 8.25% + (-5.6%) = 3.65%

Therefore, the expected rate of return on this stock is closest to 3.65 percent (d).