An investor that buys stock in a company expect to earn a return on their investments. However, it is possible that the project or investment may lose money for the company or investor. Exposure to a possible loss occurs at the time an investment is made. To compensate for this exposure to risk, an investor expects a higher possible return on investment.
For example. Suppose that economists predict a 40% chance for a boom economy in the coming year, a 20% chance for a normal economy, and a 40% chance for a recession. Suppose that in a boom economy, investor is expected to earn a 70% annual rate of return on investment, a 20% return in a normal economy and will have a negative 60% return in a recession. The question now becomes, what is the expected rate of return for Investor in the coming year? To calculate the expected rate of return E(k), we calculate a weighted average of the possible returns that investor could earn.
State of Economy Probability Possible Return Weighted Possible Boom 0.4 70% 28% Normal 0.2 20% 4% Recession 0.4 -60% -24%
Expected Return E(k) = 8%
No comments:
Post a Comment