An investor wishes to add new stocks to her portfolio. She has information about two

assets, Stock A and Stock B. Stock A has a beta of 1.25 and an expected return of 20%.

Stock B has a beta of 0.9 and expected return of 15%. The risk-free rate is 4.5% and the

market risk premium is 15%.

Which of these stocks, if any, would you advise the investor to purchase? (6 marks)

B. Huron has been told that diversifying his investments will significantly reduce risk. He has

therefore invested in two stocks. His portfolio consists of a $1 500 000 investment in Drugs

Limited and $750 000 invested in shares of Pharmaceuticals Limited.

Economy Probability Returns

Drugs Limited Pharmaceuticals Limited

Boom 0.4 12% 19%

Normal 0.5 8% 11%

Recession 0.1 2% -4%

i. What is the expected return on Hurons portfolio? (9 marks)

ii. Advise Huron as to the effectiveness of his diversification strategy. (5 marks)

(Total 20 marks)