The following table is given for stocks A and B



Chp 9- Risk, Return and the Opportunity Cost of capital

The following table is given for stocks A and B. Using the data given and answer the questions 1 thru 6.

|Scenario |Probability |Return on A |Return on B |

|Recession |25% |-4% | 9% |

|Normal |40% | 8% | 4% |

|Boom |35% |20% |-4% |

1. What is the expected return on Stock A?

a. 9.2 %

b. 8.0 %

c. 24.0 %

d. 11.3 %

2. What is the expected return on Stock B?

a. 3.0 %

b. 2.45 %

c. 4.33 %

d. 6.33 %

3. What is the standard deviation of Stock A?

a. 4.33 %

b. 6.22 %

c. 9.22 %

d. 0 %

4. What is the standard deviation of Stock B?

a. 0 %

b. 4.33 %

c. 6.22 %

d. 5.12%

5. What is the expected return of a portfolio if you invest %50 of your wealth in Stock A and %50 in Stock B?

a. 5.83 %

b. 5.5 %

c. 11.0 %

d. 0 %

6. What is the standard deviation of the portfolio if you invest %50 of your wealth in Stock A and %50 in Stock B?

a. 0 %

b. 5 %

c. 2.1 %

d. 10 %

CHP 09

Calculate the expected return, variance, and standard deviations for investments in either stock A or stock B, or an equally weighted portfolio of both.

|Scenario |Probability |Return on A |Return on B |

|Recession |25% |-4% | 9% |

|Normal |40% | 8% | 4% |

|Boom |35% |20% |-4% |

Answer:

Stock A:

Expected return = (.25 x –4%) + (.40 x 8%) + (.35 x 20%) = 9.2%

Variance = .25(-4% - 9.2%) + .4(8% - 9.2%)2 + .35(20% - 9.2%)2

= 43.56 + .58 + 40.82 = 84.96

Standard deviation = (84.92)2 = 9.22%

Stock B:

Expected return = (.25 x 9%) + (.40 x 4%) + (.35 x -4%) = 2.45%

Variance = .25(9% - 2.45%) + .4(4% - 2.45%)2 + .35(-4% - 2.45%)2

= 10.73 + .96 + 14.56 = 26.25

Standard deviation = (26.25)2 = 5.12%

Portfolio:

Expected return = (.5 x 9.2%) + (.5 x 2.45%) = 5.83%

Variance = .25(((-4% + 9%) x. 5) – 5.83%)2 + .4(((8% + 4%) x.5) – 5.83%)2

+ .35 ((20% - 4%) x.5) – 5.83%)2

= 2.77 + .01 + 1.65 = 4.43

Standard deviation = (4.43)2 = 2.1%

Note that the standard deviation of the portfolio is considerably less than that of either Stock A or Stock B.

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