Question

Consider the following scenario analysis:
Main Table Rate of return

Probability Stocks Bonds
Recession 1/3 -10% 6%

Normal Economy 1/3 15% 4%

Boom 1/3 30% 2%


a. Calculate the expected rate of return and standard deviation for both stock and bond investments.  
b. Which investment would you prefer? Why?

Answer 1

a.

Stocks

Bonds Investment

Expected Rate of return

11.67%

4.00%

Standard deviation

16.50%

1.63%

b.

Expected return of stock is higher but standard deviation is also higher.Selection of investment depend upon type of investor.If investor is agree to take risk, they will go with Stocks investment.

On the other hand, if investor is not agree to take risk , they will go with bonds investment.

Alternatively, on the basis of Coefficienct of variation, it will be preferable to Invest in Bonds having lower coefficenct of variation.

Working:

Expected Rate of return of:

Stocks

=

(1/3*-10%)+(1/3*15%)+(1/3*30%)

=

11.67%

Bonds

=

(1/3*6%)+(1/3*4%)+(1/3*2%)

=

4.00%

Variance of :

Stocks

=

(((-10%-11.67%)^2)*1/3)+(((15%-11.67%)^2)*1/3)+(((30%-11.67%)^2)*1/3)

=

2.7222%

Bonds

=

(((6%-4%)^2)*1/3)+(((4%-4%)^2)*1/3)+(((2%-4%)^2)*1/3)

=

0.0267%

Standard Deviation of:

Stocks

=

? Variance

=

? 2.7222%

=

16.50%

Bonds

=

? Variance

=

? 0.0267%

=

1.63%

Coefficient of variation of:

Stocks

=

Standard deviation/Expected Return

=

16.50%

/

11.67%

=

1.41

Bonds

=

Standard deviation/Expected Return

=

1.63%

/

4.00%

=

0.41