Question

Suppose you have two options when investing money in the stock market: stock A and stock B. The returns on both are dependent on the state of the economy, which fluctuates with the business cycle. During periods of strong economic growth, the rates of return for stock A and stock B are 16.00 and 9.00, respectively. Periods of weak growth during recessions cause the rates of return for stock A and stock B to fall to 10.00 and -3.00, respectively. Additionally, assume that an economic boom is twice as likely as an economic downturn.a) Calculate Expected return for stock Ab) Calculate expected return for stock B

Answer 1

a. 14%

b. 5%

Step-by-step explanation:

Expected return is the weighted average of the returns on a stock given the state of the economy.

Economic boom is twice as likely as an economic downturn.

Boom probability = 2/3

Downturn = 1/3

a. Expected return of stock A

= (16% * 2/3) + (10% * 1/3)

= 10.67% + 3.33%

= 14%

b. Expected return of stock B:

= (9% * 2/3) + ( -3% * 1/3)

= 6% + (-1%)

= 5%