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Problem 1: Statistical measures of standalone risk
Risk and the probabilities event occurrence vary under different circumstances. To identify an average expected return under a range of different possible outcomes, calculate the expected value of a range of possible outcomes. The expected value or return is a statistical measure of the average (mean) value of all possible outcomes.
Consider this case:
Ian owns a two-stock portfolio that invests in Falcon Company (FF) and Pheasant Pharmaceuticals (PP). Three-quarters of Ian's portfolio value consists of Falcon Freight's shares, and the balance consists of Pheasant Pharmaceuticals' 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
25%
50%
70%
Normal
45%
30%
40%
Weak
-40%
-50%
Calculate expected returns for the individual stock in Ian's portfolio as well as the expected rate of return of the entire portfolio over the three possible market conditions next year.
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