Consider an asset that costs $120 today. You are going to hold it for 1 year and then sell it. Suppose that there is a 25 percent chance that it will be worth $90 in a year, a 25 percent chance that it will be worth $130 in a year, and a 50 percent chance that it will be worth $160 in a year.

What is its average expected rate of return?

Average expected rate of return = 12.5% (Approx)

Explanation:

Given:

Cost of assets = $120

In condition 1 = 25% chance that it will be worth $90

In condition 2 = 25% chance that it will be worth $130

In condition 3 = 50% chance that it will be worth $160

Computation:

Average expected rate of return = Probability (Net worth - Cost of assets) / Cost of assets

Average expected rate of return = [25% ($90 - $120) / $120] + [25% ($130 - $120) / $120] + [50% ($160 - $120) / $120]

Average expected rate of return = [0.25 (-$30) / $120] + [0.25 ($10) / $120] + [0.50 ($40) / $120]

Average expected rate of return = [-0.0625] + [0.020833] + [0.167]

Average expected rate of return = 0.12533

Average expected rate of return = 12.5% (Approx)