Answered: Calculate expected returns for the…

EBK CONTEMPORARY FINANCIAL MANAGEMENT

14th Edition

ISBN:9781337514835

Author:MOYER

Publisher:MOYER

Chapter8: Analysis Of Risk And Return

Section: Chapter Questions

Problem 13QTD

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2. Statistical measures of stand-alone risk

Remember, the expected value of a probability distribution is a statistical measure of the average (mean) value expected to occur during all possible circumstances. To compute an asset’s expected return under a range of possible circumstances (or states of nature), multiply the anticipated return expected to result during each state of nature by its probability of occurrence.

Consider the following case:

Ethan owns a two-stock portfolio that invests in Falcon Freight Company (FF) and Pheasant Pharmaceuticals (PP). Three-quarters of Ethan’s portfolio value consists of FF’s shares, and the balance consists of PP’s shares.

Each stock’s expected return for the next year will depend on forecasted market conditions. The expected returns from the stocks in different market conditions are detailed in the following table:

Market Condition	Probability of Occurrence	Falcon Freight	Pheasant Pharmaceuticals
Strong	0.25	30%	42%
Normal	0.45	18%	24%
Weak	0.30	-24%	-30%

Calculate expected returns for the individual stocks in Ethan’s portfolio as well as the expected rate of return of the entire portfolio over the three possible market conditions next year.

•	The expected rate of return on Falcon Freight’s stock over the next year is (10.08%, 7.14%, 11.34%, 8.40%) .
•	The expected rate of return on Pheasant Pharmaceuticals’s stock over the next year is (15.25%, 13.90%, 12.30%, 8.00%).
•	The expected rate of return on Ethan’s portfolio over the next year is (7.97%, 9.38%, 12.66%, 11.26%).

The expected returns for Ethan’s portfolio were calculated based on three possible conditions in the market. Such conditions will vary from time to time, and for each condition there will be a specific outcome. These probabilities and outcomes can be represented in the form of a continuous probability distribution graph.

For example, the continuous probability distributions of rates of return on stocks for two different companies are shown on the following graph:

Based on the graph’s information, which of the following statements is true?

Company A has a smaller standard deviation.

Company B has a smaller standard deviation.

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