50.1K

Verified Solution

Link Copied!

3. Statistical measures of standalone 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 assets 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:

Musashi owns a two-stock portfolio that invests in Blue Llama Mining Company (BLM) and Hungry Whale Electronics (HWE). Three-quarters of Musashis portfolio value consists of Blue Llama Minings shares, and the balance consists of Hungry Whale Electronicss shares.

Each stocks 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	BLM	HWE
	Occurrence
Strong	50%	30%	42%
Normal	25%	18%	24%
Weak	25%	-24%	-30%

Calculate expected returns for the individual stocks in Musashis 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 Blue Llama Minings stock over the next year is .
	The expected rate of return on Hungry Whale Electronicss stock over the next year is .
	The expected rate of return on Musashis portfolio over the next year is .

The expected returns for Musashis 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 graphs information, which of the following statements is true?

Company A has a smaller standard deviation.

Company B has a smaller standard deviation.

..... www it www Marco There IA AUTY BENT Om Company A PROBABILITY DENSITY Company B -40 -30 -20 40 50 60 -100 10 20 30 RATE OF RETURN (Percent) ..... www it www Marco There IA AUTY BENT Om Company A PROBABILITY DENSITY Company B -40 -30 -20 40 50 60 -100 10 20 30 RATE OF RETURN (Percent)

Answer & Explanation Solved by verified expert

See Answer