What is the risk premium for the following returns if the risk-free rate is 4%? State Probability Return Boom .20 .75 Good .55 .25 Recession .15 -.10 Depression .10 -.20
What is the risk premium for the following returns if the risk-free rate is 4%? State Probability Return Boom .20 .75 Good .55 .25 Recession .15 -.10 Depression .10 -.20
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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Risk and return
Before understanding the concept of Risk and Return in Financial Management, understanding the two-concept Risk and return individually is necessary.
Capital Asset Pricing Model
Capital asset pricing model, also known as CAPM, shows the relationship between the expected return of the investment and the market at risk. This concept is basically used particularly in the case of stocks or shares. It is also used across finance for pricing assets that have higher risk identity and for evaluating the expected returns for the assets given the risk of those assets and also the cost of capital.
Question
![**Risk Premium Calculation**
To determine the risk premium for the following investment returns, given that the risk-free rate is 4%, refer to the table of possible economic states and their associated probabilities and returns:
| State | Probability | Return |
|-------------|-------------|--------|
| Boom | 0.20 | 0.75 |
| Good | 0.55 | 0.25 |
| Recession | 0.15 | -0.10 |
| Depression | 0.10 | -0.20 |
**Steps to Calculate Expected Return:**
1. Multiply each return by its probability.
2. Sum these values to get the expected return.
**Calculate the Risk Premium:**
\[ \text{Risk Premium} = \text{Expected Return} - \text{Risk-Free Rate} \]
**Answer Choices:**
- 0.3325
- 0.1525
- 0.0525
- 0.1825
- 0.2225
The correct choice corresponds to the calculated risk premium based on the expected return.](/v2/_next/image?url=https%3A%2F%2Fcontent.bartleby.com%2Fqna-images%2Fquestion%2F537cca7c-787a-475d-9aba-926e9a602de3%2Fa1a3d50b-b5b0-4ab0-bf65-8a074be07496%2F802xlun_processed.jpeg&w=3840&q=75)
Transcribed Image Text:**Risk Premium Calculation**
To determine the risk premium for the following investment returns, given that the risk-free rate is 4%, refer to the table of possible economic states and their associated probabilities and returns:
| State | Probability | Return |
|-------------|-------------|--------|
| Boom | 0.20 | 0.75 |
| Good | 0.55 | 0.25 |
| Recession | 0.15 | -0.10 |
| Depression | 0.10 | -0.20 |
**Steps to Calculate Expected Return:**
1. Multiply each return by its probability.
2. Sum these values to get the expected return.
**Calculate the Risk Premium:**
\[ \text{Risk Premium} = \text{Expected Return} - \text{Risk-Free Rate} \]
**Answer Choices:**
- 0.3325
- 0.1525
- 0.0525
- 0.1825
- 0.2225
The correct choice corresponds to the calculated risk premium based on the expected return.
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