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

Expected Return when future is good =Weight of A*Return of A when future is good+Weight of B*Return of B when future is good =50%*10%+50%*3% =6.5%
Expected Return when future is very good =Weight of A*Return of A when future is very good+Weight of B*Return of B when future is very good =50%*15%+50%*6% =10.5%

Expected Return of Portfolio =Probability of Good*Expected Return when future is good+Probability of very good*Expected Return when future is very good =35%*6.5%+65%*10.5% =9.1%

Option d is correct option about 9%