You have decided to invest 30 percent in X; 30 percent in Y; and 40 percent in Z

Question

You have decided to invest 30 percent in X; 30 percent in Y; and 40 percent in Z. The probability of the state of the economy is Boom 25%; Normal 60%; and, Bust 15%. The rate of return for stock X is Boom .20; Normal .15; and, Bust .00. The rate of return for stock Y is Boom .35; Normal .10; and, Bust -.30. The rate of return for stock Z is Boom .60; Normal .05; Bust -.40.
   A] What is the portfolio expected return?

   B] If the expected T-bill rate is 1.5 percent, what is the expected risk premium on the portfolio?

Explanation / Answer

Computation of portfolio Expected Return.We have,

Step1: Computation of expected retrun of individual stoks X,Y & Z.We have,

Step2: Computation of expected return of porfolio.We have,

Expected Return = (0.30 x 0.14) + (0.1025 x 0.30 ) + ( 0.12 x 0.40) = 0.042 + 0.0308 + 0.048 = 0.1208*100 = 12.08 %

Hence, The expected return of the portfolio is 12.08 %.

Particulars Probability Return of stock X Return of stock Y Return of stock Z Probability x Return of stock X Probability x Return of stock Y Probability x Return of stock Z Boom 0.25 0.20 0.35 0.60 0.05 0.0875 0.15 Normal 0.60 0.15 0.10 0.05 0.09 0.06 0.03 Bust 0.15 0.00 -0.30 -0.40 0.00 -0.045 -0.06 Total 0.14 0.1025 0.12

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