Ima’s sister, Uma, has completed her own analysis of the company and Wallnut’s s

Question

Ima’s sister, Uma, has completed her own analysis of the company and Wallnut’s stock. Uma used recession, constant growth, and inflation scenarios, but with different probabilities and expected stock returns. Uma believes the probability of recession is quite high, at 60 percent, and that in a recession, Wallnut’s stock return will be -20 percent. Uma believes the scenarios of constant growth and inflation are equally likely and that Wallnut’s returns will be 15 percent in the constant growth scenario and 10 percent under the inflation scenario.

Explanation / Answer

- Scenarios of constant growth and inflation are equally likely, this means that the probability associated with the two scenarios is 20% each.

- Expected return of Wallnut stock = (-20 x 60%) + (15 x 20%) + (10 x 20%) = -7%

- Variance = [(-20 + 7)2 x 0.6] + [(15 + 7)2 x 0.2] + [(10 + 7)2 x 0.2] = 256

- Standard deviation = 2561/2 = 16%

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