In: Finance
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State
of
Probability
of
Return on Return on
Economy State
Occurring Stock A Stock B
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Bust
0.10
–0.10 (or –10%) 0.05 (or 5%)
Normal 0.60 0.15 (or
15%)
0.10 (or 10%)
Boom 0.30 0.25 (or 25%) 0.40 (or 40%)
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a) Find the expected return on each stock.
Use at least six decimal places when computing (b), (c), and (d) below to minimize rounding errors.
b) Compute the variance and standard deviation of returns of
each stock.
c) Find the covariance and correlation between the returns on Stock
A and Stock B.
d) Assume that you form a portfolio consisting of Stock A and Stock
B. You invest $3,000
in Stock A and $7,000 in Stock B.
i) Find the weight of each stock in the portfolio.
ii) Find the expected return and standard deviation of returns on
the portfolio
consisting of Stock A and Stock B.