There are two stocks, A and B. In Fin6301, we have discussed the concept of a portfolio, which is just a basket of several stocks. Under any circumstance, if you invest 40% of your money in Stock A and the rest (60%) in Stock B, the portfolio return Rp = 40%*RA+60%*RB. Suppose the possible returns next year and the corresponding probabilities are given as follows,

Possible State of Economy	Probability	RA	RB	Rp1	Rp2
Recession	.25	-5%	10%
Normal	.4	10%	15%
Growth	.35	15%	5%

Your financial advisor recommended two portfolios constructed using both stocks with portfolio P1 investing 20% in Stock A, while portfolio P2 investing 60% in Stock A.

(a) What are the returns of each portfolio in each state of the economy?

(b) What are the expected returns for stocks A and B, and portfolios P1 and P2, i.e., E(RA), E(RB),

E(Rp1), and E(Rp2)?

(c) Comparing Stock A with portfolio P2, will you be better off by holding the portfolio? (hint: also

consider their volatilities)

(d) Comparing Stock B with portfolio P1, does reduction in volatility justify loss in expected return

when holding the portfolio?