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Consider the following two, completely separate, economies. The expected return and volatility of all stocks in...

Consider the following two, completely separate, economies. The expected return and volatility of all stocks in both economies is the same. In the first economy, all stocks move together – in good times all prices rise together and in bad times they all fall together. In the second economy, stock returns are independent – one stock increasing in price has no effect on the prices of other stocks. Assuming you are risk-averse, and you could choose one of the two economies in which to invest, which one would you choose? Explain.

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Expert Solution

I will be choosing the the SECOND economy because stock prices are independent and stock return are completely different from one another as one stock is increasing in pricing has no effect on the prices of the Other stocks, and it is reflecting a high level of diversification in the economy, and there is no level of positive correlation like in the first economy so I will be trying to have an exposure towards second economy because it is providing a high level of diversification and the correlation is very lower, so when I am investing into the second economy,I will be highly diversified and I will be hedged towards any unsystematic risk associated with my portfolio and my unsystematic risk will be highly eliminated due to low correlation and presence of diversification because stock returns are not following each other.

I will not invest in first economy because it is providing with no diversification and it is providing with a high correlation so this is a perfect positive correlation and I will be avoiding first economy.

Therefore I will be looking to invest into the SECOND economy which is offering with a high level of diversification and low level of correlation and elimination of the unsystematic risk so I will be trying to take an exposure in the second economy.

jeff jeffy answered 1 year ago
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