Consider the following information about three stocks: What are the approximate

Question

Consider the following information about three stocks:   

  

What are the approximate and exact expected real risk premiums on the portfolio? (Round your answers to 2 decimal places. (e.g., 32.16))

Rate of Return if State Occurs   State of Probability of   Economy State of Economy Stock A Stock B Stock C   Boom .20 .28 .40 .56   Normal .45 .22 .20 .18   Bust .35 .00 .20 .48

  

c-2

What are the approximate and exact expected real risk premiums on the portfolio? (Round your answers to 2 decimal places. (e.g., 32.16))

     Approximate expected real risk premium %   Exact expected real risk premium %

Explanation / Answer

stock A Stock B Stock C State of probability return return p*rB return p*rC economy p rA p*rA rB rC Boom 0.2 0.28 0.056 0.4 0.08 0.56 0.112 Normal 0.45 0.22 0.099 0.2 0.09 0.18 0.081 Bust 0.35 0 0 -0.2 -0.07 -0.48 -0.168 Expected return 0.155 0.1 0.025 Expected Return of Stock A 0.155 or 15.50% Expected Return of Stock B 0.1 or 10.00% Expected Return of Stock C 0.025 or 2.50% Let us assume the following 1. stocks have equal weights in the portfolio 2. Inflation rate = 2% 3. risk-free rate = 3% Expected return of Portfolio   = wA* rA + wB*rB + wC * rC where wA, wB and wC are weights of the stocks in the portfolio Expected return on Portfolio = =1/3 *15.5%+1/3*10% + 1/3*2.5% 0.093333 or 9.33% Approximated expected real risk premium   = Expected return on portfolio - risk-free rate 6.33% Exact expected real risk premium   = Approximate expected real risk premium /(1+inflation rate) Exact expected real risk premium = 6.33%/(1+2%) 0.062092 or 6.21%

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