Question 4 (20 marks)

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
Good	0.1	40%	-6%
Normal	0.7	24%	18%
Bad	0.2	-14%	30%

Variables	Stock A	Stock B
Expected Return	---	18%
Standard Deviation	---	9.3%
Beta	1	0.75

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

(6 marks)

(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)

show calculation step please!!!! Important