Assume that in the next year the economy will experience high growth (20% probability), normal growth (40% probability), or a recession (40% probability). Assume that the stock market is procyclical (does well when the economy does well), such that its return in the next year will be one of the following: State of the economy Probability Stock-market return High growth .20 +30% Normal growth .40 +12.5% Recession .40 -15%
a. According to these numbers, what is the expected return on stocks over the next year?
b. If one-year Treasury bonds are currently paying 2% interest, then what is the risk premium on stocks?