HINOYOG, NOVA E.

BSBA – 3D

Part 1. Exercise

Problem 1. With the probabilities summing to 100%. An investor is contemplating to make a risky Php100,000
investment, where there is a 25% chance of receiving no return at all. There is also a 50% probability of generating a
Php10,000 return, and a 25% chance that the investment will create a Php50,000 return. Based on this information,
calculate the expected rate of return.

Expected return = 0.2 (25%) + 0.5 (50%) + 0.3 (25%)

= 5% + 25% + 7.5%

= 37.5%

Therefore, the probable long-term average return for the Investments of the investor is 37.5%.

Problem 2. You are thinking about investing your money in the stock market. You have the following three stocks in
mind: stock A, B, and C. You know that the economy is expected to behave according to the following table. You also
believe that the likelihood of each scenario is identical (the sum of all probabilities is similar with Problem 1, thus, all
states of nature have equal probabilities). Which among the three investments has the highest percentage of
volatility? Justify your answer.

State of the Economy RA RB RC

Depression -20% 5% -5%
Recession 10% 20% 5%
Normal 30% -12% 5%
Boom 50% 9% -3%

ANSWER

E(RA) = (0.25) (-0.20) + (0.25) (0.10) + (0.25) (0.30) + (0.25) (0.50)

= -0.05 + 0.025 + 0.075 + 0.125

= 0.175 (17.5%)

E(RB) = (0.25) (0.05) + (0.25) (0.20) + (0.25) (-0.12) + (0.25) (0.09)

= 0.0125 + 0.05 - 0.03 + 0.0225

= 0.055 (5.5%)

E(RC) = (0.25) (-0.05) + (0.25) (0.05) + (0.25) (0.05) + (0.25) (-0.03)

= -0.0125 + 0.0125 + 0.0125 - 0.0075

= 0.005 (0.5%)

Among the three investments stock A has the highest percentage of volatility.