While evaluating a stock, you estimate that it will earn a return of 11 percent if economic conditions are favorable, and 3 percent if economic conditions are unfavorable. Given the probabilities of favorable versus unfavorable economic conditions, you conclude that the stock will earn 7.2 percent next year. The 7.2 percent figure is called the:

Question

BlackTom AI · Accepted Answer

Let's unpack the question and the terminology step by step.
Option 1: 'expected return.' The scenario describes estimating two possible returns (11% if favorable, 3% if unfavorable) and weighting them by the probabilities of each economic condition to obtain a single figure (7.2%). This is precisely the definition of the expected return: the probability-weighted average of possible returns.
Option 2: 'geometric return.' The geometric return reflects the compound growth rate over multiple periods, calculated as the nth root of the product of (1 + period returns) minus 1. It is not the simple probability-weighted average of alternative outcomes for a single period, so this is not the correct label for 7.2% in this context.
Option 3: 'arithmetic return.' The arithmetic return is the simple average of possible returns, often computed as (R1 + R2) / 2 when outcomes are equally likely, or otherwise as a simple average without weighting by probabilities. In this case, the figure 7.2% arises from probability weighting, not a straightforward unweighted or simple average, so this is not the right term here.
Option 4: 'required return.' The required return is the minimum return investors demand for accepting risk, often used as a discount rate in valuation. It is a benchmark or hurdle rate, not the probability-weighted expectation of returns given scenarios, so this option mislabels the concept.
Option 5: 'historical return.' A historical return is the actual return observed in the past, not a forward-looking, probability-weighted estimate based on scenario analysis. Therefore this option does not fit the described 7.2% figure.
In summary, the 7.2 percent figure is best described as the expected return, since it combines possible outcomes with their associated probabilities to yield a single probabilistic forecast for next year.

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