Problem 05-04 (Algo) Assume that the economy can experience high growth, normal

ID: 2810576 • Letter: P

Question

Problem 05-04 (Algo) Assume that the economy can experience high growth, normal growth, or recession. Under these conditions, you expect the following stock market returns for the coming year: State of the Econom High Growth Normal Growth Recession Probabilit 0.2 0.7 0.1 Return 25% 11% a. Compute the expected value of a $1,000 investment over the coming year. If you invest $1,000 today, how much money do you expect to have next year? What is the percentage expected rate of return? Instructions: Enter dollar values rounded to the nearest whole dollar and percentages rounded to one decimal place The expected value is $ 1126 and the expected rate of return is 12.61%. b. Compute the standard deviation of the percentage return over the coming year. Standard deviation-L 71 % c. If the risk-free return is 7 percent, what is the risk premium for a stock market investment? Risk premium-1 561%

Explanation / Answer

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State of Economy

Probability = P

Return = R

Product = P x R

High growth

0.20

25.00%

5.00000%

Normal growth

0.70

11.00%

7.70000%

Recession

0.10

-1.00%

-0.10000%

Expected Return = Total =

12.60000%

Expected Return

12.60%

Standard deviation of return = [Sum (Probability x (Return - Expected return)]^0.5

Standard deviation of return = (0.2*(25%-12.6%)^2 + 0.70*(11%-12.6%)^2 + 0.10*(-1%-12.6%)^2)^0.5

Standard deviation =

7.1%