Murphy, who has retired for several years, is considering investing in two stocks: A and B. The returns and other related estimates for the two stocks under different states of the world in the coming year are estimated as follows:

(a) Calculate the expected rate of return and standard deviation of Stock A.

(b) If Murphy could only invest in either Stock A or Stock B, which asset should he choose? Explain.

(c) Assume that the covariance between Stock A and Stock B is -0.01055842 or -105.5842%2. Compute the expected return and standard deviation of returns of Portfolio AB in which 40% of its value is invested in Stock A and the remainder in Stock B.

(d) If Murphy could choose to invest in between Stock A, Stock B and the Portfolio AB, which should he invest in? Explain.

(e) Assume the risk-free rate is 4% and the market risk premium is 19.5%. Based on CAPM, should Murphy invest in the Portfolio AB?

Probability State of the World Good Normal Bad 0.1 0.7 0.2 Rate of Return if State Occurs Stock A Stock B 40% 24% 18% -14% 30% Stock A Stock B Variables Expected Return Standard Deviation 18% - 9.3% Beta 1 0.75