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CMA Intermediate · Financial Management and Business Data Analytics · Risk and Return

A share of Kaveri Textiles Ltd has the following probability distribution of returns: 20% probability of 10% return, 50% probability of 16% return and 30% probability of 22% return. What is the expected return on the share?

The expected return is 16.6%. It is the probability-weighted average of the outcomes: 0.2 times 10 plus 0.5 times 16 plus 0.3 times 22 gives 2.0 plus 8.0 plus 6.6. The simple average of 16% ignores the unequal probabilities.

  1. A16.0%
  2. B16.6%Correct
  3. C17.2%
  4. D15.4%

Explanation

Expected return = 0.20x10 + 0.50x16 + 0.30x22 = 2.0 + 8.0 + 6.6 = 16.6%. The simple average of the three returns (10+16+22)/3 = 16.0% ignores the probability weights, so it is wrong.

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