Consider an asset that costs $130 today. You are going to hold it for 1 year and then sell it. Suppose that there is a

Question

Consider an asset that costs $130 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 $120 in a year, and a 50 percent chance that it will be worth $160 in a year. a. 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 $140 today. c. Does the increase in the current price increase or decrease the asset's average expected rate of return? Decrease or increase d. At what price would the asset have a zero average expected rate of return?

Help In Homework · Accepted Answer

a. Computation of Average Expected Rate of Return: Expected Selling Price of the Asset after 1 Year = Sum of the product of prices and their respective probabilities = $100 * 0.25 + $120 * 0.25 + $160 * 0.50 = $135 Average Expected Rate of Return = [(Expected selling price after 1 year - Cost of the asset today)/Cost of the asset today] * 100 = [($135 - $130)/$130] * 100 = [$5/$130] * 100 = 3.85% b. Computation of Average Expected Rate of Return if its Current Price were $140 today: Cost of the asset today = $140 Expected Rate of Return = [(Expected selling price after 1 year - Cost of the asset today)/Cost of the asset today] * 100 = [($135 - $140)/$140] * 100 = [-$5/$140] * 100 = -3.57% c. An increase in the current price decreases the asset's average expected rate of return. ? d. If the average expected rate of return is zero, then the current price of the asset must be equal to the expected price of the asset after 1 year. Therefore, Current price = Expected price after 1 year = $135

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Consider an asset that costs $130 today

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