Question

On January 1, you forecasted that there is a 45 percent chance that the stock price of Edward Bear Inc. will be $95 in one year while there is a 55 percent chance that the stock price will be $35. Six months later, you revised the estimated probability to 25 percent chance of the high state (stock price of $95). If the market agrees with your revised forecasts, what is the expected change in stock price from January 1 to July 1? Assume the discount rate is zero.

A) Price goes up by 19.35%

B) Price goes down by 19.35%

C) Price goes up by 24%

D) Price goes down by 24%

Answer 1

Computation of stock price as on Jan 1st

Probability of stock price $ 95 = 0.45

Probability of stock price $ 35= 0.55

Stock price on Jan 1st = Stock price * Probability

= $95( 0.45) + $ 35( 0.55)

= $ 42.75+$ 19.25

=$ 62

Computation of stock price as on July1st

Probability of stock price $ 95 = 0.25

Probability of stock price $ 35= 1-0.25= 0.75

Stock price on July 1st = Stock price * Probability

= $95( 0.25) + $ 35( 0.75)

= $ 23.75+$ 26.25

=$ 50

Expected Change in Stock price from Jan 1st to July 1st = (Closing stock price -Opening stock price)/ Opening stock price

= $ 50- $ 62 / $ 62

= -$ 12/62

=-0.1935

Hence the Prices goes down by 19.35%. So option B) is correct.

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