Question

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.

Answer 1

Answer : Correct Option is (c.) About 8%

Reason :

Expected return = Sum of (Probability * Return)

Expected Return on Stock A = [10% * (1 - 0.35)] + [15% * 0.35]

= [10% * 0.65] + 5.25%

= 6.5% + 5.25%

= 11.75%

Expected Return on Stock B = [3% * (1 - 0.35)] + [6% * 0.35]

= [3% * 0.65] + 2.1%

= 1.95% + 2.1%

= 4.05%

Expected Return on Portfolio = [Expected Return on Stock A * Weight of A] + [Expected Return on Stock B * Weight of B]

= [11.75 % *0.50 ] + [4.05% * 0.50]

= 5.875% + 2.025%

= 7.9% or 8%