Question

The stock of Blue Water Tours, Inc. is expected to return 14.00 percent in a boom economy, 9.00 percent in a normal economy, and lose 8.00 percent in a recessionary economy. What is the expected rate of return on this stock if there is a 10.00 percent chance the economy booms, and an 85.00 percent chance the economy will be normal?

Answer 1

Answer:

 Economy type             Expected return          Weightage    Weighted Average

Boom                                 14%                             10%           0.14*0.10= 0.014

Normal                               9%                             85%          0.85*0.090=.0765

Recession                          -8%                             5%           -0.08*0.05=-0.004

Add all the weigtage averages (0.014+0.0765-0.004)= 0.0865= 8.65%

The expected rate of return of the stock is 8.65%

Explanation:

In this question we need to find the weighted average returns, we know the expected return during a boom, normal and recession and we need to use the probabilities of boom, normal and recession as the weights, so the event which is most likely to happen will have the most weightage, this way we can find the expected return of the stock. There is a 85% chance that there will be a normal economy so the expected return in a normal economy will have the highest weightage.