1.

2. Marco Witz is following two stocks on the financial market, stock A and stock B. Their return distributions are given in the following table:

State	Prob.	Stock A	Stock B
1	0.3	8%	2%
2	0.2	5.5%	-3%
3	0.5	-1%	4%

1. Help him evaluate the two stocks. Find expected return and volatility of each stock as well as their covariance and correlation coefficient.
2. Determine the expected return and volatility of a portfolio with 60% invested in Stock A and the remainder invested in Stock B.
3. Intuitively explain the concept of diversification between two stocks. Is diversification always at work for any two stocks that we pick? Quantify the risk-reducing effect of diversification for the portfolio in 2b.

3. Steel Inc. (SI) has the following end-of-year cash flows per share: $400 with a probability of 0.78 when there is no severe workplace accident, or $300 with a probability of 0.22 in case of a severe workplace accident. The risk-free rate is 2%, the expected return of the market is 4%, and SIs beta factor is given by 1.5.

1. Find the expected return on SI stock with the help of the CAPM.
2. Find the value of SI stock. If you buy SI stock at this price, what are the two possible end-of-year returns?
3. Determine the value of SI stock if the company buys workers compensation insurance that fully reimburses all losses. Distinguish between a scenario with an actuarially fair premium and a scenario with a 20% loading.

1. Capital asset pricing model (9 points). Complete the following table using the CAPM. The risk-free rate is 2%. Parameter ridenotes the expected return of security i, o the vola- tility of security i, Bi the beta factor of security i, Oim the covariance between security i and the market portfolio (in %), and Pim the correlation between security i and the mar- ket. Security i can be the market portfolio (i = m), stock 1 (i = 1) or stock 2 (i = 2). ri Oi Bi Oim (in %) Pim 10% Market port- folio (i = m) Stock 1 (i = 1) Stock 2 (i = 2) 5% 5% 1.5 46 0.35 1. Capital asset pricing model (9 points). Complete the following table using the CAPM. The risk-free rate is 2%. Parameter ridenotes the expected return of security i, o the vola- tility of security i, Bi the beta factor of security i, Oim the covariance between security i and the market portfolio (in %), and Pim the correlation between security i and the mar- ket. Security i can be the market portfolio (i = m), stock 1 (i = 1) or stock 2 (i = 2). ri Oi Bi Oim (in %) Pim 10% Market port- folio (i = m) Stock 1 (i = 1) Stock 2 (i = 2) 5% 5% 1.5 46 0.35