13.

Hull Consultants, a famous think tank in the Midwest, has provided probability
estimates for the four potential economic states for the coming year. The probability
of a boom economy is 10%, the probability of a stable growth economy is 15%, the
probability of a stagnant economy is 50%, and the probability of a recession is 25%.
Estimate the expected return on the following individual investments for the coming
year.

Forecasted Returns for Each Economy

INVESTMENT Boom Stable Growth Stagnant Recession
Stock 25% 12% 4% -12%
Corporate Bond 9% 7% 5% 3%
Government Bond 8% 6% 4% 2%

ANSWER

Expected Return Stock = 0.10 x 0.25 + 0.15 x 0.12 + 0.50 x 0.04 + 0.25 x (-0.12)

= 0.0250 + 0.0180 + 0.0200 - 0.0300 = 0.0330 or 3.3%

Expected Return Corp. Bond = 0.10 x 0.09 + 0.15 x 0.07 + 0.50 x 0.05 + 0.25 x 0.03

= 0.0090 + 0.0105 + 0.0250 + 0.0075 = 0.0520 or 5.2%

Expected Return Gov. Bond = 0.10 x 0.08 + 0.15 x 0.06 + 0.50 x 0.04 + 0.25 x 0.02

= 0.0080 + 0.0090 + 0.0200 + 0.0050 = 0.0420 or 4.2%

14. Variance and Standard Deviation (expected). Using the data from problem 13,
calculate the variance and standard deviation of the three investments, stock,
corporate bond, and government bond. If the estimates for both the probabilities of the
economy and the returns in each state of the economy are correct, which investment
would you choose considering both risk and return? Why?

ANSWER

Variance of Stock = 0.10 x (0.25 – 0.033)2 + 0.15 x (0.12 – 0.033)2

+ 0.50 x (0.04 – 0.033)2 + 0.25 x (-0.12 – 0.033)2

= 0.10 x 0.0471 + 0.15 x 0.0076 + 0.50 x 0.0000 + 0.25 x 0.0234

= 0.0047 + 0.0011 + 0.0000 + 0.0059 = 0.0117 or 1.17%

Standard Deviation of Stock = (0.0117)1/2 = 0.1083 or 10.83%

Variance of Corp. Bond = 0.10 x (0.09 – 0.052)2 + 0.15 x (0.07 – 0.052)2
+ 0.50 x (0.05 – 0.052)2 + 0.25 x (0.03 – 0.052)2

= 0.10 x 0.0014 + 0.15 x 0.0003 + 0.50 x 0.0000 + 0.25 x 0.0005

= 0.0001 + 0.0000 + 0.0000 + 0.0001 = 0.000316 or 0.0316%

Standard Deviation of Corp. Bond = (0.0004)1/2 = 0.01776 or 1.78%

Variance of Gov. Bond = 0.10 x (0.08 – 0.042)2 + 0.15 x (0.06 – 0.042)2

+ 0.50 x (0.04 – 0.042)2 + 0.25 x (0.02 – 0.042)2

= 0.10 x 0.0014 + 0.15 x 0.0003 + 0.50 x 0.0000 + 0.25 x 0.0005

= 0.0001 + 0.0000 + 0.0000 + 0.0001 = 0.000316 or 0.0316%

Standard Deviation of Gov. Bond = (0.000316)1/2 = 0.01776 or 1.78%

The best choice is the corporate bond. First comparing the corporate bond and the stock, the
corporate bond has a higher expected return and a lower variance (standard deviation).
Second comparing the corporate bond and the government bond the corporate bond has a
higher return and the same variance (standard deviation). This result is due to the low
probabilities of “good” economic states where the stock performs best.