Question

. You are considering purchasing stock S. This stock has an expected return of 8% if the economy booms and 3% if the economy goes into a recession. The overall expected return will:
A. be equal to one-half of 8% if there is a 50% chance of an economic boom.
B. vary inversely with the growth of the economy.
C. decrease as the probability of a recession increases.
D. decrease as the probability of a boom economy increases.

Answer 1

HI,

a stock overall return = probability of boom* boom return +probability of recession* recession return

Now boom return = 8%

recession return = 3%

now we will consider each option.

option a says if boom chances =50% then recession chances =50%

hence overall return =1/2*8%+1/2*3%

hence option a is incorrect.

now option b) as we know that return at the time of boom is more, so overall return will also vary directly with growth of economy hence second option is also wrong here.

C) now if recession probability increases then boom probability of boom gets down. and if that happens then overall return will also go down. Hence this option is correct.

D) Based on option C option D is wrong

Hence option C is correct here.

Thanks