An investment firm is considering a portfolio with equal weighting in a cyclical stock and a countercyclical stock. It is expected that there will be three economic states; Good, Average and Bad, each with equal probabilities of occurrence. The cyclical stock is expected to have returns of 12%, 5% and 1% in Good, Average and Bad economies respectively. The countercyclical stock is expected to have returns of -8%, 2% and 14% in Good, Average and Bad economies respectively. Given this information, calculate portfolio expected return.
A) 2.32%
B) 3.32%
C) 4.32%
D) 5.32%
E) 6.32%

Question

Quizplus · Accepted Answer

The expected return of the portfolio is the weighted average of the expected returns of the two stocks. Since the stocks have equal weighting, the expected return of the portfolio is the average of the expected returns of the two stocks. The expected return of the cyclical stock is (12% + 5% + 1%) / 3 = 6%. The expected return of the countercyclical stock is (-8% + 2% + 14%) / 3 = 3%. Therefore, the expected return of the portfolio is (6% + 3%) / 2 = 4.5%.

An Investment Firm Is Considering a Portfolio with Equal Weighting