financial projects

Assignment: Based upon this problem and solution answer the questions: In financial investments, it is possible to encounter withtwo major issues that the investors
need to understand before placing their money into any particular financial projects. These issues are risks and returns that are involved in the investments. In most
scenario business investors are more interested in what they will make of the returns of the investments. The returns are usually calculated based on a given time or
period of investment.
In most investments, it is not possible to tell the actual returns that an investment will bring forth but with simple financial information, it is possible to
calculate or project the expected benefits. Expected return is the term used to explain the amount one anticipates to receive from an investment that contains known or
expected rates of return. The rate of return is a percentage of the investment cost that explains a gain or loss of the profit over a specific period. Some investments
(such as lotteries) present very positive returns despite having low probabilities of achieving those returns. This paper explores risk investment decision making
based on return rates and probabilities of return.
Question:
Suppose that the percentage of the annual return you obtain when you invest a dollar in gold, or the stock market is dependent on the general state of the national
economy as indicated below. For example, the probability that the economy will be in “boom” state is 0.15. In this case, if you invest in the stock market your return
is assumed to be 25%; on the other hand, if you invest in gold when the economy is in a “boom” state your return will be minus 30% and likewise for the other possible
states of the economy. Note that the sum of the probabilities has to be 1 ? and is.
State of economy
Probability
Market Return
Gold Return
Boom
0.15
25%
-30%
Moderate Growth
0.35
20%
-9%
Weak Growth
0.25
5%
35%
No Growth
0.25
-14%
50% Based on the expected return, would you rather invest your money in the stock market or in gold? Why?
Solution:
Using the probability procedure:
Provided with the probability distribution of returns, one can calculate the expected return from the following equation: Where
? E[R] is the expected return on the stock,
? K is the number of states,
? Pi is the probability of state i, and
? Ri is the return on the stock in state i. Case 1: Market Expected Return
state of economy
Probability
Market Return
weighted return
Boom
0.15
25%
3.75%
Moderate Growth
0.35
20%
7.00%
Weak Growth
0.25
5%
1.25%
No Growth
0.25
-14%
-3.50%
Expected return for stock market investment =
8.50% Case 2: Gold Expected Return state of economy
Probability
Gold Return
weighted return
Boom
0.15
-30%
-4.50%
Moderate Growth
0.35
-9%
-3.15%
Weak Growth
0.25
35%
8.75%
No Growth
0.25
50%
12.50%
Expected return for Gold investment =
13.60% The expected return of investing in the stock market is the 8.50%, and the expected return of investing in Gold is 13.60%. Both investments are worth the risk
since they have positive expected returns, but Gold is a better investment since it has a higher positive expected return.Questions: Can you calculate the standard
deviation? Once you do so, does the additional information cause you to change your decision?

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