Assume that in the next year the economy will experience high growth (20% probab

Question

Assume that in the next year the economy will experience high growth (20% probability), normal growth (40% probability), or a recession (40% probability). Assume that the stock market is procyclical (does well when the economy does well), such that its return in the next year will be one of the following: State of the economy Probability Stock-market return High growth .20 +30% Normal growth .40 +12.5% Recession .40 -15%

a. According to these numbers, what is the expected return on stocks over the next year?

b. If one-year Treasury bonds are currently paying 2% interest, then what is the risk premium on stocks?

Explanation / Answer

(a) Expected return = 0.2 x 30% + 0.4 x 12.5% - 0.4 x 15% = 6% + 5% - 6% = 5%

(b) Risk premium = Expected return - Interest on treasury bonds = 5% - 2% = 3%

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