Question

A stock had returns of 5.10%, 31.60%, and -21.20% in each of the past three years. Over the past four years, the arithmetic average annual return for the stock was 4.75%. What was the geometric annual return for the stock over the past four years?a. 2.91% (plus or minus 0.02 percentage points)b. 3.06% (plus or minus 0.02 percentage points)c. 3.37% (plus or minus 0.02 percentage points)d. 5.07% (plus or minus 0.02 percentage points)e. None of the above is within 0.02 percentage points of the correct answer

Answer 1

The correct option is c. 3.37% (plus or minus 0.02 percentage points).

Step-by-step explanation:

Note that since we are asked to find the geometric annual return for the stock over the past four years but we are only given the stock returns for each of the past three years, this implies that the stock return to be used for the first year of the past four years will be the arithmetic average annual return for the stock over the past four years.

Therefore, the geometric annual return for the stock over the past four years can now be computed using the following formula:

Geometric average return = {[(1 + r1) * (1 + r2) * (1 + r3) * (1 + r4)]^(1/4)} - 1 ....... (1)

Where;

r1 = Stock return in year 1 = arithmetic average annual return = 4.75%, or 0.0475

r2 = Stock return in year 2 = 5.10%, or 0.0510

r3 = Stock return in year 3 = 31.60%, or 0.3160

r4 = Stock return in year 4 = -21.20%, or -0.2120

Substituting the values into equation (1), we have:

Geometric average return = {[(1 + 0.0475) * (1 + 0.0510) * (1 + 0.3160) * (1 - 0.2120)]^(1/4)} - 1

Geometric average return = 1.14166543988^(1/4) - 1

Geometric average return = 1.03367666813442 - 1

Geometric average return = 0.03367666813442, or 3.367666813442%

Rounding to 2 decimal places, we have:

Geometric average return = 3.37%

Therefore, the correct option is c. 3.37% (plus or minus 0.02 percentage points).