Question 9

There are two stocks in the market, Stock A and Stock B . The price of Stock A today is GH 75. The price of Stock A next year will be GH64 if the economy is in a recession, GH 87 if the economy is normal, and GH97 if the economy is expanding. The probabilities of recession, normal times, and expansion are 0.2, 0.6, and 0.2, respectively. Stock A pays no dividends and has a correlation of 0.7 with the market portfolio. Stock B has an expected return of 14 percent, a standard deviation of 34 percent, a correlation with the market portfolio of 0.24, and a correlation with Stock A of 0.36. The market portfolio has a standard deviation of 18 percent. Assume the CAPM holds.

If you are a typical, risk-averse investor with a well-diversified portfolio, which stock would you prefer? Why?

What are the expected return and standard deviation of a portfolio consisting of 70 percent of Stock A and 30 percent of Stock B ?

What is the beta of the portfolio in part (b)?