Question

QUESTION 26

After some study of the economy, your forecast for next year is that a boom economy has a 30% chance of occurring, a neutral economy 50%, and a bust economy a 20% chance of occurring. You also estimate that a certain stock would have a return of 32% in a boom economy next year, 21% in a neutral economy , and -10% in a bust economy. The risk-free rate is 4.4%. What is the expected risk premium for this stock next year? (Answer to the nearest tenth of a percent, but do not use a percent sign).
  

	Probability	Return
Boom Economy	30%	32%
Neutral Economy	50%	21%
Bust Economy	20%	-10%

Risk-Free Rate = 4.4%

Answer 1

Probability of Boom Economy = 30%
Return in Boom Economy = 32%
Probability of Neutral Economy = 50%
Return in Neutral Economy = 21%
Probability of Bust Economy = 20%
Return in Bust Economy = -10%

Expected Return = Probability of Boom Economy * Return in Boom Economy + Probability of Neutral Economy * Return in Neutral Economy + Probability of Bust Economy * Return in Bust Economy
Expected Return = 30% * 32% + 50% * 21% + 20% * (-10%)
Expected Return = 18.10%

Expected Risk Premium = Expected Return - Risk-free Rate
Expected Risk Premium = 18.10% - 4.40%
Expected Risk Premium = 13.70%