Economy will improve vastly next year, and that many freight customers will gradually switch from cheaper sea freight to faster airfreight. Hence, you are interested to invest in the stocks of two listed companies, Delta Aircraft Ltd and Alpha Air Ltd. Delta Aircrafts manufactures airfreight planes for goods forwarders like DHL. Alpha Air produces software and hardware for airfreight planes. The following information applies for the following year in the table listed below State of Return on Delta Return On Alpha The Economy Strong 0.7 14% 22% Normal And Weak 0.3 6% 3% Required: a. Compute the expected returns and the standard deviation of returns for each stock. b. Compute the covariance between the returns of the two stocks. c. Compute the expected return and standard deviation of a portfolio that comprise 60 percent of funds in Delta Aircrafts and the balance in Alpha Air d. Given your answers in parts a, b and c above, evaluate the diversification effect of combining the two stocks in a portfolio.
Risk and return
Before understanding the concept of Risk and Return in Financial Management, understanding the two-concept Risk and return individually is necessary.
Capital Asset Pricing Model
Capital asset pricing model, also known as CAPM, shows the relationship between the expected return of the investment and the market at risk. This concept is basically used particularly in the case of stocks or shares. It is also used across finance for pricing assets that have higher risk identity and for evaluating the expected returns for the assets given the risk of those assets and also the cost of capital.
Economy will improve vastly next year, and that many freight customers will gradually switch from cheaper sea freight to faster airfreight. Hence, you are interested to invest in the stocks of two listed companies,
Delta Aircraft Ltd and Alpha Air Ltd. Delta Aircrafts manufactures airfreight planes for goods forwarders like DHL. Alpha Air produces software and hardware for airfreight planes.
The following information applies for the following year in the table listed below
| State of | Return on Delta | Return On Alpha | |
| The Economy | |||
| Strong | 0.7 | 14% | 22% |
| Normal And Weak | 0.3 | 6% | 3% |
Required:
a. Compute the expected returns and the standard deviation of returns for each stock.
b. Compute the covariance between the returns of the two stocks.
c. Compute the expected return and standard deviation of a portfolio that comprise 60 percent of funds in Delta Aircrafts and the balance in Alpha Air
d. Given your answers in parts a, b and c above, evaluate the diversification effect of combining the two stocks in a portfolio.
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