A risk-free investment of $50,000 offers an annual return of 6%. A risky investment of $50,000 has a 40% probability of default, in which case it will pay only $25,000.
-Refer to the information above. What is the expected rate of return on the risky investment?
A)+8.4%
B)-22.0%
C)-16.4%
D)+7.8%

Question

Quizplus · Accepted Answer

Expected return of the risky investment = (probability of no default)*(return if no default) + (probability of default)*(return if default)
= (60%)*(6%) + (40%)*(-25%/50%) = 3.6% - 8%
= -4.4%
The risk-free investment with a guaranteed return of 6% is a better choice than the risky investment with an expected return of -4.4%.

A Risk-Free Investment of $50,000 Offers an Annual Return of 6