Question

Which one of the following statements is correct concerning the expected rate of return on an individual stock given various states of the economy?
a. The expected return is an arithmetic average of the individual returns for each state of the economy.
b. As long as the total probabilities of the economic states equal 100%, then the expected return on the stock is a geometric average of the expected returns for each economic state.
c. The expected return is equal to the summation of the values computed by dividing the expected return for each economic state by the probability of the state.
d. The expected return is a geometric average where the probabilities of the economic states are used as the exponential powers.
e. The expected return is a weighted average of the returns where the probabilities of the economic states are used as the weights.

Answer 1

Answer: e. The expected return is a weighted average of the returns where the probabilities of the economic states are used as the weights.

Explanation:

When calculating the expected return of a stock given the probabilities that different economic states would occur and the returns of the stock should those states occur, we use the probabilities as weights to get the weighted average of the returns given. This is the expected return.

Formula looks like this:

Expected return = (Probability that economy is good * return if economy is good) + (Probability that economy is average * return if economy is average) + (Probability that economy is poor * return if economy is poor)