Answer

Interview Question: Consider the following investment:

Cost of investment: $1,000

2 equally likely events: Pays $800 in a weak economy and $1,400 in a strong economy

The risk free rate is 4%.

1) Calculate the expected return of the investment.

2) Calculate the expected return

3) Calculate the implied market risk premium.

Answer:

1) Calculate the expected payoff. Since both outcomes are equally likely:

0.5 * $800 + 0.5 * 1,400 = $1,100 = Expected payoff

2) Expected return = Expected gain / Investment cost

Expected return = (1,100 – 1,000) / 1,000 = 10%

3) Market risk premium = Market return – risk free return = 10% – 4% = 6%