Look again at Tables 13.1 and 13.2. Suppose you think a boom will only occur 20 percent of the time instead of 50 percent. What are the expected returns on Stocks U and L in this case? If the risk-free rate is 10 percent, what are the risk premiums?
Table 13.1
States of the economy and stock returns
| Rate of Return if State Occurs | |||
| Stock U | Stock L | Probability of State of Economy | State of Economy |
| 30% | -20% | .50 | Recession |
| 10 | 70% | \frac {.50}{1.00} | Boom |
Table 13.2
Calculation of expected return
| Stock U | Stock L | ||||
| (6) Product (2)×(5) | (5) Rate of Return if State Occurs | (4) Product (2)×(3) | (3) Rate of Return if State Occurs | (2) Probability of State of Economy | (1) State of Economy |
| .15 | .30 | -.10 | -.20 | .50 | Recession |
| E(R_{U})=\frac{.05}{20\%} | .10 | E(R_{L})=\frac{.35}{25\%} | .70 | \frac {.50}{1.00} | Boom |
