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 return must the risky investment promise?
A)8.1%
B)43.3%
C)71.7%
D)62.0%

Question

Quizplus · Accepted Answer

The risky investment must promise a return that, on average, equals the return of the risk-free investment. The expected return from the risky investment is calculated as follows: 60% chance of achieving the promised return (since there's a 40% chance of default) and a 40% chance of getting $25,000 back on a $50,000 investment (which is a -50% return). Let x be the promised return when there's no default. The equation to balance the expected return with the risk-free return of 6% is: 0.6 * x + 0.4 * (-50%) = 6%. Solving for x gives x = 43.3%.

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