There are two stocks, A and B. In Fin6301, we have discussed the concept of a...

There are two stocks, A and B. In Fin6301, we have discussed the concept of a portfolio, which is just a basket of several stocks. Under any circumstance, if you invest 40% of your money in Stock A and the rest (60%) in Stock B, the portfolio return Rp = 40%*RA+60%*RB. Suppose the possible returns next year and the corresponding probabilities are given as follows,

Possible State of Economy	Probability	RA	RB	Rp1	Rp2
Recession	.25	-5%	10%
Normal	.4	10%	15%
Growth	.35	15%	5%

Your financial advisor recommended two portfolios constructed using both stocks with portfolio P1 investing 20% in Stock A, while portfolio P2 investing 60% in Stock A.

(a) What are the returns of each portfolio in each state of the economy?

(b) What are the expected returns for stocks A and B, and portfolios P1 and P2, i.e., E(RA), E(RB),

E(Rp1), and E(Rp2)?

(c) Comparing Stock A with portfolio P2, will you be better off by holding the portfolio? (hint: also

consider their volatilities)

(d) Comparing Stock B with portfolio P1, does reduction in volatility justify loss in expected return

when holding the portfolio?

Expert Solution

Please refer to below spreadsheet for calculation and answer. Cell reference also provided.

Cell reference -

Hope this will help, please do comment if you need any further explanation. Your feedback would be appreciated.

jeff jeffy answered 3 months ago

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