Question

You are considering purchasing stock S. This stock has an expected return of 12 percent if the economy booms, 8 percent if the economy is normal, and 3 percent if the economy goes into a recessionary period. The overall expected rate of return on this stock will:

Answer 1

Answer: e. increase as the probability of a boom economy increases.

Explanation:

The overall expected return of this stock will be the weighted average of the stock's performance in different economic periods.

From the question it is shown that the stock has the highest return when the economy is at a boom. If the probability of a boom increases therefore, the overall expected return will increase as well.

For instance: If the probability of a boom is 40%, normal is 50% and recession is 10%, the expected return will be;

= (40% * 12%) + (50% * 8%) + (10% * 3%)

= 9.1%

Now if the probability of boom changes such that: boom is 60%, normal is 30% and recession remains at 10%. Expected return is;

= (60% * 12%) + (30% * 8%) + (10% * 3%)

= 9.9%

Notice how the overall expected return increased thereby confirming option e.