Scenario Probability Return on stock A Return on stock B Boom 50% 20% 2% Normal 25%...

Scenario	Probability	Return on stock A	Return on stock B
Boom	50%	20%	2%
Normal	25%	15%	6%
Recession	25%	10%	12%

a) If you invest 70% of your funds into stock A and 30% into stock B, what is the expected return of your portfolio in each state of the economy?

b) Use your knowledge of risk and return to explain why the portfolio is more heavily invested in Asset A (70%) than Asset B (30%).

c) What is the overall expected portfolio rate of return?

d) What is the standard deviation of the portfolio?

e) Based on your knowledge of diversification, would you predict that the individual standard deviations of assets A & B be higher, lower or equal to your answer in part d above?

Solutions

Expert Solution

ANSWER IN THE IMAGE. FEEL FREE TO ASK ANY DOUBTS. THUMBS UP PLEASE.

B. Risk- Reward Relationship:

There is a direct relationship between the risk associated and the return gained.

As per Risk-Reward Relationship: The higher the risk(standard deviation) associated with the portfolio/security, the higher the return expected and vice-versa.

That's why to obtain a higher return in the portfolio, a higher weight is given to Stock A.

E.
The standard deviation of the portfolio is not the weighted average standard deviation. it is due to the benefit of diversification due to the non-perfect relationship between the stocks.

It is usually less than the weighted average standard deviation.

If there is a perfect correlation between stocks in the portfolio then it is the weighted average standard deviation. Although, this is not the case in almost any scenario.

The standard deviation of the portfolio of two stocks is:
[(Weight*Sd)^2+(Weight*Sd)^2+2*(Weight*Weight)*Sd*Sd*correlation]^0.5

jeff jeffy answered 1 year ago

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