State of Economy Probability of State of Economy Rate of Return if State Occurs: Stock A Rate of Return if State Occurs: Stock B Rate of Return if State Occurs: Stock C Boom .25 .27 .15 .11 Normal .65 .14 .11 .09 Bust .10 -.19 -.04 .05 A portfolio is invested 45 percent each in Stock A and Stock B and 10 percent in Stock C. What is the expected risk premium on the portfolio if the expected T-bill rate is 3.2 percent?

The expected risk premium on the portfolio if the expected T-bill rate is 3.2 percent is 8.71%

Explanation:

Stock A               ReturnPROBABILITY  Return × Investment

BOOM                  27%         25%                          6.75%

NORMAL         14.00%      65%                          9.10%

BUST                -19.00%      10%                          -1.90%

                                                 Total                         13.95%

Stock B              ReturnPROBABILITY          Return × Investment

BOOM          15%          25%                    3.75%

NORMAL          11.00%    65%                  7.15%

BUST          -4.00%        10%                  -0.40%

                                                       Total          10.50%

Stock C            Return          PROBABILITYReturn × Investment

BOOM                11%             25%                             2.75%

NORMAL      9.00%     65%                             5.85%

BUST              5.00%     10%                             0.50%

                                                   Total                            9.10%

PORTFOLIO      ReturnPROBABILITY  Return × Investment

STOCK A        14%             45%                      6.28%

STOCK B       10.50%      45%                      4.73%

STOCK C       9.10%      10%                     0.91%

                                                   Total                        11.91%

EXPECTED RISK PREMIUM  =Market return - Risk free return

= 11.91% - 3.2%  

= 8.71%

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