Recitation 2

Fall 2020

Question 1
Suppose there are three economic states next year. Suppose that state 1 occurs
with probability 0.3, state 2 occurs with probability 0.4, and state 3 occurs with
probability 0.3. There is a riskless bond that pays is $100 in all three states,
that is, [$100,$100,$100]. This bond is currently traded at $96. There is a risky
stock that pays the following amounts in each state: [$120,$75,$130]. The stock
is currently traded at $80.
(a) What is the return on the bond?
(b) What is the expected return of the stock?

Solutions:
(a) Expected payoff:

E (B) = 0.3 ⇥ $100 + 0.4 ⇥ $100 + 0.3 ⇥ $100 = $100.

Expected return:

E (B) P 100 96
r̄ = = = 4.17%.
P 96

(b) Expected payoff:

E (S) = 0.3 ⇥ $120 + 0.4 ⇥ $75 + 0.3 ⇥ $130 = $105.

Expected return:

E (S) P 105 80
r̄ = = = 31.25%.
P 80