Question

In: Finance

Answer the following question based on the information below: State of Economy Probability Stock A’s return...

Answer the following question based on the information below:

State of Economy

Probability

Stock A’s return

Stock B’s return

Boom

.4

15%

- 30%

Recession

.6

5%

40%

Which of the following statements is true?

a) Stock A has higher expected return than stock B.

b) The actual return of stock A will always be greater than that of stock B.

c) Stock A has higher total risk than stock B.

d) Stocks A and B are positively correlated.

Solutions

Expert Solution

True statements are as follows:

  • Stock B has higher expected return than stock A.
  • The actual return of stock A will always be greater than that of stock B.
  • Stock B has higher total risk than stock A.
  • Stocks A and B are negatively correlated.

Working Note

1) Stock A

State of Economy Probability (P) Return(%) Probability*Return Deviation form expected return (D1) PD1^2
Boom 0.4 15 6.00 6.00 14.40
Recession 0.6 5 3.00 -4.00 9.60

Expected return = Probability*Return

= 6+3

= 9%

Variance = PD^2

= 14.4+9.6

= 24

Standard Deviation = Variance

= 24

= 4.90%

*Deviation form expected return = Rate of return -  expected return

2) Stock B

State of Economy Probability (P) Return(%) Probability*Return Deviation form expected return (D2) PD2^2
Boom 0.4 -30 -12.00 -42.00 705.60
Recession 0.6 40 24.00 28.00 470.40

Expected return = Probability*Return

= -12+24

= 12%

Variance = PD^2

= 705.6+470.4

= 1176

Standard Deviation = Variance

= 1176

= 34.29%

Probability (P) Deviation (D1) Deviation (D2) PD1D2
0.4 6.00 -42.00 -100.80
0.6 -4.00 28.00 -67.20

Covariance = PD1D2

= -100.80-67.20

= -168

Correlation = Covariance/SDA*SDB

= -168/(4.9*34.29)

= -0.99


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