Consider an asset that costs $140 today. You are going to hold it for 1 year and
ID: 1114158 • Letter: C
Question
Consider an asset that costs $140 today. You are going to hold it for 1 year and then sell it. Suppose that there is a 25 percent chance that it will be worth $100 in a year, a 25 percent chance that it will be worth $130 in a year, and a 50 percent chance that it will be worth $170 in a year.
. What is its average expected rate of return?
b. Next, figure out what the investment’s average expected rate of return would be if its current price were $150 today.
c. Does the increase in the current price increase or decrease the asset’s average expected rate of return?
d. At what price would the asset have a zero average expected rate of return?
Explanation / Answer
A.
Expected value of asset = 100*25% + 130*25% + 170*50%
Expected value of asset = $142.5
Average expected return = (142.5-140)*100/140
Average expected return = 1.785%
B.
If current price is $150,
Average expected return = (142.5 - 150)*100/150
Average expected return = -5%
C.
It decreases the average expected return as the current price is higher than the expected price of asset found in the part A.
D.
For a zero average expected rate of return,
Price = $142.5
At this price
Average expected rate of return = (142.5-142.5)/142.5
Average expected rate of return = 0