Q2(a) There are two stocks in the market, Stock A and Stock B. The price of Stock A today is GHe 79. The price of Stock A next year will be GH¢64 if the economy is in a recession, GH¢ 87 if the economy is normal, and GH¢97 if the economy is expanding. The probabilities of recession, normal times, and expansion are 0.4, 0.4, 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 25 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. i. If you are a typical, risk-averse investor with a well-diversified portfolio, which stock would you prefer? Why? ii. What are the expected return and standard deviation of a portfolio consisting of 60 percent of Stock A and 40 percent of Stock B ? 111. What is the beta of the portfolio in part (ii)? Q2(b) Carefully reflect on the Capital Asset Pricing Model and Arbitrage Pricing Theory. Briefly explain two features common to them.

Q2(a) There are two stocks in the market, Stock A and Stock B. The price of Stock A today is GHe 79. The price of Stock A next year will be GH¢64 if the economy is in a recession, GH¢ 87 if the economy is normal, and GH¢97 if the economy is expanding. The probabilities of recession, normal times, and expansion are 0.4, 0.4, 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 25 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. i. If you are a typical, risk-averse investor with a well-diversified portfolio, which stock would you prefer? Why? ii. What are the expected return and standard deviation of a portfolio consisting of 60 percent of Stock A and 40 percent of Stock B ? 111. What is the beta of the portfolio in part (ii)? Q2(b) Carefully reflect on the Capital Asset Pricing Model and Arbitrage Pricing Theory. Briefly explain two features common to them.

EBK CONTEMPORARY FINANCIAL MANAGEMENT

14th Edition

ISBN:9781337514835

Author:MOYER

Publisher:MOYER

Chapter8: Analysis Of Risk And Return

Section: Chapter Questions

Problem 26P

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Question

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Q2(a) There are two stocks in the market, Stock A and Stock B. The price of Stock A today is GHe 79. The price
of Stock A next year will be GH¢64 if the economy is in a recession, GH¢ 87 if the economy is normal, and
GH¢97 if the economy is expanding. The probabilities of recession, normal times, and expansion are 0.4, 0.4,
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 25 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.
i.
If you are a typical, risk-averse investor with a well-diversified portfolio, which stock would you
prefer? Why?
ii.
What are the expected return and standard deviation of a portfolio consisting of 60 percent of Stock A
and 40 percent of Stock B ?
111.
What is the beta of the portfolio in part (ii)?
Q2(b) Carefully reflect on the Capital Asset Pricing Model and Arbitrage Pricing Theory. Briefly explain two
features common to them.

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