Two stocks, stock A and B, are available in the stock market. The price of the stock A today is $50. The price of stock A next year will be $40 if the economy is in a recession, $55 if the economy is normal, and $60 if the economy is expanding. The probabilities of recession, normal times, and expansion are 0.1, 0.8, and 0.1, respectively. Stock A pays no dividends and has a correlation of 0.8 with the market portfolio. Stock B has an expected return of 9 percent, a standard deviation of 12 percent, a correlation with the market portfolio of 0.2 and a correlation with stock A of 0.6. The market portfolio has a standard deviation of 10 percent. Assume CAPM holds.

Required:

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

(5 marks)

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

(5 marks)

3. What are your considerations if you would like to include additional stocks in your investment portfolio? Explain briefly.

(3 marks)

4. You believe that stock market is efficient, and investors are not able to generate abnormal return from the market. Explain your possible strategies based on your belief.

(2 marks)