A stock is expected to earn 36 percent in a boom economy, 20.00 percent in a nor

Question

A stock is expected to earn 36 percent in a boom economy, 20.00 percent in a normal economy, and lose 20 percent in a recessionary economy. There is a 16 percent chance the economy will boom and a 60 percent chance the economy will be normal. What is the expected risk premium for this stock if the risk-free rate is expected to be 5.40 percent?

6.16 percent

7.56 percent

7.27 percent

6.60 percent

A stock is expected to earn 36 percent in a boom economy, 20.00 percent in a normal economy, and lose 20 percent in a recessionary economy. There is a 16 percent chance the economy will boom and a 60 percent chance the economy will be normal. What is the expected risk premium for this stock if the risk-free rate is expected to be 5.40 percent?

Explanation / Answer

Answer:

Calculation of expected return of the stock:

Formula :

Expected return = (Return 1* Probability 1 ) + (Return 2* Probability 2 )+

(Return 3* Probability 3 )

= (36%*16%) + (20%*60%) + (-20%*(100-16-60)%)

= 12.96%

Expected risk premium = Expected Return on stock - Risk Free rate

=12.96% - 5.4%

=7.56%

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