1. You are considering the purchase of two stocks, A and B. The initial price of each stock is $100. The price of the stocks at the end of the year depend on the state of the economy over the year as follows (neither stock pays a dividend):

Price in One Year

State of Economy Probability Stock A Stock B

Boom .15 115 125

Moderately Growth .65 108 112

Recession .20 92 85

1. What are the expected rates of return and standard deviations for A and B?
2. If the risk-free rate is 2.50%, what is the risk premium on stock A? What is the risk premium on stock B? Which stock has the better risk-reward tradeoff as measured by the Sharpe ratio?
3. Assess your own risk tolerance using the questionnaire in your text on page 164. If you are a conservative investor, (i.e. you got 9 points or less) set A=6. If you are a moderate investor (i.e. you got 10 to 17 points) set A=4. If you are an aggressive investor, (i.e you got 18 points or more) set A=2. Your utility function is U = r^e As². You can invest in either Stock B or T-bills (risk-free rate = 2.50%). What is your certainty equivalent rate of return? Which will you choose? What is the level of risk aversion for which you would be indifferent between Stock B and T-bills? (Within your group, there should be a moderate, a conservative and an aggressive investor. Please give me answers for all three types of investor.)