You are considering the beginning of a portfolio. You want to keep it simple how

Question

You are considering the beginning of a portfolio. You want to keep it simple however, by only having it contain two assets. Unfortunately, you have narrowed it down to FOUR, not two. So, now you are going to do the final cuts using an expected return analysis. You believe the best way to determine the state of the economy is to use the consumer confidence index (CCI)- Those values, along with the returns on each of your four securities are included in the following table. You feel that any CCI value less than 80 is a contradictory period. Alternatively, and CCI value more than 86 is an expansionary period. Anywhere in between is a normal period. a. If you believe that next year will be characterized by a 10% chance of an expansion, a 60% chance of a contraction, and a 30% chance of a normal period, what is the expected return of each?

Explanation / Answer

We first sum up the return as per the confidence index between the range provided for each period, then calculate the following:

Expected returns for the Stocks:

Returns collected under various periods /Stock Expected returns / Stock Period Probability of Period A B C D A B C D Expansion 10% 30.6 17.7 35.5 23.5 3.06 1.77 3.55 2.35 Contraction 60% 14.2 23.7 2 16.3 8.52 14.22 1.2 9.78 Normal 30% 31.3 40.7 29.6 26.7 9.39 12.21 8.88 8.01 EXPECTED RETURNS (%) 20.97 28.20 13.63 20.14

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