Question 1

Consider the following information about two stocks where the probability of an economic boom is 40%:

Economic State Return A (RA) Return B (RB)

Boom 38% 6%

Recession -4% 12%

1.1. Calculate the expected return for stock A and stock B.

1.2. Calculate the standard deviation of stock A and stock B.

1.3. Calculate the correlation between stock A and stock B.

1.4. Calculate the total risk (standard deviation) of a portfolio, where 1/8 of your money is invested in stock A, and 7/8 of your money is invested in stock B. (Hint: use the method with the formula for the risk of a portfolio (i.e., using the covariance)).

1.5. Calculate the expected return on a portfolio with equal proportions in the risky assets, and 30% in a risk-free asset which has a return of 10%.