The expected return on a security is currently based on a 22 percent chance of a 15 percent return given an economic boom and a 78 percent chance of a 12 percent return given a normal economy.Which of the following changes will decrease the expected return on this security?
I.An increase in the probability of an economic boom
II.A decrease in the rate of return given a normal economy
III.An increase in the probability of a normal economy
IV.An increase in the rate of return given an economic boom
A)I and II only
B)I and IV only
C)II and III only
D)I, III, and IV only
E)I, II, III, and IV

Question

Quizplus · Accepted Answer

The expected return on the security is calculated as follows: 
Expected return = (probability of economic boom * rate of return in boom) + (probability of normal economy * rate of return in normal economy) 
Expected return = (0.22 * 15) + (0.78 * 12) 
Expected return = 12.84%

I. An increase in the probability of an economic boom would increase the expected return. Therefore, option I is incorrect. 
II. A decrease in the rate of return given a normal economy would decrease the expected return. Therefore, option II is correct. 
III. An increase in the probability of a normal economy would also decrease the expected return since the rate of return in a normal economy is lower than in a boom, and the probability of a normal economy is higher. Therefore, option III is correct. 
IV. An increase in the rate of return given an economic boom would increase the expected return. Therefore, option IV is incorrect.

Therefore, the correct answer is C - II and III only.

The Expected Return on a Security Is Currently Based on a 22