7. The expected return on a security is currently based on a 0.42 chance of a 12

Question

7. The expected return on a security is currently based on a 0.42 chance of a 12 percent return given an economic boom, and a 0.58 chance of a 7 percent return given a normal economy. Which of the following changes will reduce the expected return on this security?
I. the probability of an economic boom decreases     II. the rate of return given an economic boom increases
III. the probability of a normal economy increases   IV. the rate of return given a normal economy increases

why is the answer II and IV?

The expected return on a security is currently based on a 0.42 chance of a 12 percent return given an economic boom, and a 0.58 chance of a 7 percent return given a normal economy. Which of the following changes will reduce the expected return on this security? I. the probability of an economic boom decreases II. the rate of return given an economic boom increases III. the probability of a normal economy increases IV. the rate of return given a normal economy increases why is the answer II and IV?

Explanation / Answer

Hi,

Please find the answer as follows:

Current Expected Return = Probability of Boom Period*Return during Boom Period + Probability of Normal Economy*Return during Economy Period = .42*12 + .58*7 = 9.1%

As, evident from above calculations, expected return would decrease in case of Option 1 and Option 3.

Thanks.

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