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You recently purchased a stock that is expected to earn 25 percent in a booming economy,...

You recently purchased a stock that is expected to earn 25 percent in a booming economy, 10 percent in a normal economy, and lose 38 percent in a recessionary economy. There is a 10 percent probability of a boom and a 75 percent chance of a normal economy. What is your expected rate of return on this stock?

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Answer #1

Expected Return = Weighted Average

Let the probability be P and returns be X. The total of the PX column is the Expected Return

The expected return of the stock is 4.30%.

Notes

  • How did we find the probability in the recessionary economy

The total of probability has to be 1

= 1 - Probability of Boom - Probability of Normal

=1 - 0.10 - 0.75

= 0.15

  • As we are losing 38% recessionary economy we will show it as negative return or -38%.
  • Probability 10% can be written as 0.10

Probability 75% can be written as 0.75

Probability 15% can be written as 0.15

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