Question

Suppose security C is expected to be worth $800 if the economy is weak and $300 if the economy is strong in one year (with equal probabilities). Currently, the price of the security is $500.

Compute possible rates of return for the security over the coming year.

Compute expected rate of return of the security

Find range for possible values o returns

Suppose that on average returns of other risky securities in the market fluctuate in the range of ± 25% around their respective means. Based on your answer in c) should security C be considered more/less risky than the average?

Think again – is security C more/less risky than the average?

Answer 1

Possible return if economy is WEAK

= 800- 500/ 500 = 60%

Possible return on security C if economy is STRONG

=300-500/500 = -40%

Expected rate of return of the security = 60%*(0.5) + (-40%)*(0.5)= 10%

Range for possible values = Maximum value - Minimum value

= 60%- (-40%)

= 100%

Standard deviation formula =   

Therefore, Standard deviation =   ±50%

Since standard deviation of security C is higher than average, it is MORE RISKY than average.