Question

Dominic owns a two-stock portfolio that invests in Falcon Freight Company (FF) and Pheasant Pharmaceuticals (PP). Three-quarters of Dominic’s portfolio value consists of FF’s shares, and the balance consists of PP’s shares.

Each stock’s expected return for the next year will depend on forecasted market conditions. The expected returns from the stocks in different market conditions are detailed in the following table:

Market Condition	Probability of Occurrence	Falcon Freight	Pheasant Pharmaceuticals
Strong	0.50	40%	56%
Normal	0.25	24%	32%
Weak	0.25	-32%	-40%

Calculate expected returns for the individual stocks in Dominic’s portfolio as well as the expected rate of return of the entire portfolio over the three possible market conditions next year.

•	The expected rate of return on Falcon Freight’s stock over the next year is ____ .
•	The expected rate of return on Pheasant Pharmaceuticals’s stock over the next year is ______ .
•	The expected rate of return on Dominic’s portfolio over the next year is _______ .

Answer 1

The expected rate of return on Falcon Freight’s stock over the next year is 18%

The expected rate of return on Falcon Freight’s stock over the next year is 26%

The expected rate of return on Dominic’s portfolio over the next year is 20%

Expected return of each stock is multiplied against its corresponding probability for each of the market conditions. The sum of these products will give the overall expected return for the stock as a whole as shown below'

the excel formulas

the expected return on the portfolio is,

=   ( expected return on FF X weight of FF )    +   (expected return on PP X weight of PP)

            =              (    18% X   0.75)                           +    (   26%    X 0.25 )

           =              13.5%                                             +      6.5%

           =     20%