Question
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
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: State of the World Probability Rate of Return if State Occurs Stock A Stock B Normal Bad 0.7 0.2 Variables Expected Return Standard Deviation Beta --- --- 1 18% 9.3% 0.75 Stock A Stock B (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. (3 marks) (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. (6 marks) (d) If Murphy could choose to invest in between Stock A, Stock B and the Portfolio AB, which should he invest in? Explain. (2 marks) (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? (3 marks)
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