Suppose there are only two possible future states of nature: Good and Very Good. There is a 35% probability that the future will be Very Good. Suppose also that there are two stocks: A and B. Stock A will return 10% if the future is Good and will return 15% if the future is Very Good. Stock B will return 3% if the future is Good and 6% if the future is Very Good. If you have a portfolio that contains equal amounts of Stock A and B, what will be the expected return of this portfolio?Select one:
a. About 6%
b. About 7%
c. About 8%
d. About 9%
e. None of the above.
The portfolio expected return is computed as shown below:
= return of stock A x weight of stock A + return of stock B x weight of stock B
Return of stock A is computed as follows:
= Prob of good x return in good + Prob of very good x return in very good
= (1 - 0.35) x 0.10 + 0.35 x 0.15
= 11.75%
Return of stock B is computed as follows:
= Prob of good x return in good + Prob of very good x return in very good
= (1 - 0.35) x 0.03 + 0.35 x 0.06
= 4.05%
So, the expected return will be computed as follows:
= 0.50 x 0.1175 + 0.50 x 0.0405
= 7.9% which can be said to be about 8%
So, the correct answer is option c.
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