Assume that the economy can experience high growth, normal growth, or recession.

Question

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:

Probability

Return

0.2

40%

0.7

14%

0.1

-1%

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 the nearest tenth (1 decimal place).

The expected value is $ and the expected rate of return is %.

b. Compute the standard deviation of the percentage return over the coming year.

Standard deviation = %.

c. If the risk-free return is 7 percent, what is the risk premium for a stock market investment?

Risk premium = %.

State of the Economy

Probability

Return

        High Growth

0.2

40%

        Normal Growth

0.7

14%

        Recession

0.1

-1%

Explanation / Answer

x x*prob x^2*p State of the Economy Probability Return Actual return for 1000         High Growth 0.2 40% 400 80 32000         Normal Growth 0.7 14% 140 98 13720         Recession 0.1 -1% -10 -1 10 Total 177 45730 Mean 177 Variance 14401 Std dev 120.0042

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