Question

P13-6 Calculating Expected Return [LO1] Consider the following information: State of Economy Probability of State of Economy Rate of Return if State Occurs Recession .11 –.08 Normal .45 .14 Boom .44 .29 Calculate the expected return. Multiple Choice 18.18% 17.27% 18.91% 19.09% 2.33%

Answer 1

Expected return is the return that an investor expects to receive on his investments. When we are predicting something in the future, it is based on certain conditions and hence we have various probabilities associated with different rates of return.

To calculate the expected return, we will multiply the probability of occurrence of a particular state of the economy with its return and then add all these together.

Let us compute the given data in a tabular form and find the expected return,

State of economy	Probability	Rate of return (%)	Probability x rate of return
Recession	0.11	-0.08	0.0088
Normal	0.45	0.14	0.063
Boom	0.44	0.29	0.1276

When we take the total of the last column we get,

Expected return= -0.0088 + 0.063 + 0.1276

= 0.1818 or 18.18%

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