Question

Consider the following case: Dominic owns a two-stock portfolio that invests in Falcon Freight Company (FF) and Pheasant Pharmaceuticals (PP). Three-quarters of Dominic'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 50% 28% 39% Normal 25% 17% 22% Weak 25% -22% -28% Calculate expected returns for the individual stocks in Dominic'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 • The expected rate of return on Pheasant Pharmaceuticals's stock over the next year is • The expected rate of return on Dominic's portfolio over the next year is

Answer 1

Expected return on Falcon flight = 0.5 * 28% + 0.25*17% + 0.25* -22% = 12.75%

Expected return on Pheasant pharma = 0.5* 39% + 0.25 * 22%+ 0.25* -28% = 18%

Expected return on Dominic's portfolio = 2/3 * 12.75% + 1/3 * 18% = 14.5% (since 2/3 rd is invested in FF and rest in Pheasant)

From the graph , it is clear that Company A has lower risk since the rate of return ranges between 0% and 20% while the rate of return for B ranges between -20 to 50