NISM Certifications · NISM-Series-XV: Research Analyst · Fundamentals of Risk and Return
A stock has the following possible returns for next year: 10% with probability 0.3, 15% with probability 0.5 and 20% with probability 0.2. What is its expected return?
The expected return is 14.5%. It is the probability-weighted average: 0.3×10% plus 0.5×15% plus 0.2×20% equals 3 plus 7.5 plus 4. Taking the simple average of 15% would ignore the unequal probabilities.
- A15.0%
- B14.5%Correct
- C15.5%
- D13.5%
Explanation
Expected return = 0.3×10 + 0.5×15 + 0.2×20 = 3 + 7.5 + 4 = 14.5%. The simple average of the three returns gives 15%, which ignores the probability weights.
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