The price of some stock today is $300. Assume that the stock\'s value in one yea

Question

The price of some stock today is $300. Assume that the stock's value in one year is a random variable X with the following probability distribution: P(X = 400) = 0.1, P(X=350) = 0.4, P(X=300) = 0.3, P(X=270) = 0.2. a) Compute the expected value E(X), which represents the expected price of the stock in one year. b) What is the expected return of investing into this stock? (Hint, ignoring dividends, the expected return on the stock is given by mu R = E(X) / Price today). c) Assume there is a riskless bond in the economy that yields a (certain) return of 4% a year. This is lower than the expected return from the stock you found above. Will some people in this economy choose to hold the bond? Why would they do so? Explain.

Explanation / Answer

a. E(x) = x*p(x) for all x = 324

b. return, R = (324/300)-1 = 8%

c. some people would choose to hold the riskless bond because there is an assured return of 4%. In case they hold the stock, there is a greater than 50% chance of losing the money. The risk of holding the stock given by the standard deviation = 97.8 which is very high

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