Question

Consider the following information:

State of the economy Probability of the Economy Stock A Stock B St ock C

Boom 0.25 0.35 0.45 0.25

Normal 0.50 0.20 0.25 0.15

POOR 0.25 -0.10 -0.15 -0.10

a. Calculate the Expected returns of the stocks individually.

b. Now, you have the expected values of the stocks, assume that, Your portfolio is invested 30% each in stock A and stock B. What is the return of the portfolio?

Answer 1

(a) Calculation of expected return of stock A:
State	Probability(a)	Return(%) (b)	(a)*(b)
Boom	0.25	0.35	0.0875
Normal	0.5	0.2	0.1
Poor	0.25	-0.1	-0.025
	Expected Return		0.1625
Therefore expected return of stock A is 16.25%
Calculation of expected return of stock B:
State	Probability(a)	Return(%) (b)	(a)*(b)
Boom	0.25	0.45	0.1125
Normal	0.5	0.25	0.125
Poor	0.25	-0.15	-0.0375
	Expected Return		0.2000
Therefore expected return of stock B is 20.00%
Calculation of expected return of stock C:
State	Probability(a)	Return(%) (b)	(a)*(b)
Boom	0.25	0.25	0.0625
Normal	0.5	0.15	0.075
Poor	0.25	-0.1	-0.025
	Expected Return		0.1125
Therefore expected return of stock C is 11.25%
b) Return of protfolio= return of A*weight of A+ return of B*weight of B+ return of C*weight of C
= 16.25*0.30+20*0.30+ 11.25*0.40= 4.875+6+4.50=15.375%
Return of portfolio=15.375%