Question

1. What is the expected return of an equally weighted portfolio comprised of the following three stocks?

   State of Economy	Probability of State of Economy	Rate of Return if State Occurs
   		Stock A			Stock B			Stock C
   Boom	.25		.19			.13			.07
   Normal	.72		.15			.05			.13
   Bust	.03	−	.29		−	.14			.22

   	A.	10.37 percent
   	B.	10.96 percent
   	C.	9.48 percent
   	D.	9.82 percent

Answer 1

Expected return of portfolio is weighted average expected return of individual stocks.

Expected return for stock is weighted average return, where weights is probability of occurence of each event.

For Stock A, E(R) = 0.25 * 0.19 + 0.72 * 0.15 + 0.03 * -0.29 = 0.1468

For Stock B, E(R) = 0.25 * 0.13 + 0.72 * 0.05 + 0.03 * -0.14 = 0.0643

For Stock C, E(R) = 0.25 * -0.29 + 0.72 * -0.14 + 0.03 * 0.22 = 0.1177

Since portfolio is formed by equal weightage of each stock,

Expected portfolio return = (1/3) * 0.1468 + (1/3) * 0.0643 + (1/3) * 0.1177

Expected portfolio return = 0.0489 + 0.0214 + 0.0392 = 10.96%(Option B)