You have also decided that you have a risk-aversion (A) of 4. (a) What is the expected return for each of the securities? (b) What is the volatility of each security return? (c) What is the covariance between stock and bond returns?

Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
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You have also decided that you have a risk-aversion (A) of 4.
(a) What is the expected return for each of the securities?
(b) What is the volatility of each security return?
(c) What is the covariance between stock and bond returns?
(d) If you combine stocks and bills as an investment, what is your optimal combination? What is your expected return? What is your
portfolio’s volatility?
(e) If you combine bonds and bills, what is your optimal combination?
What is your expected return? What is your portfolio’s volatility?
(f) If you combine stocks and bonds, what is your optimal combination?
What is your expected return? What is your portfolio’s volatility?
(g) If you combine all three assets in your portfolio, what is your optimal combination? What is your expected return? What is your
portfolio’s volatility? 

1. You are trying to plan your investments for the next year. You have
decided that the market will either be strong (a bull market), weak (a
bear market) or normal. You think that stocks, bonds, and bills will earn
the following returns in these scenarios:
Probability
Scenario
Bull market
Normal market
Bear market
Stock
Bond
Return Return
0.20
0.25
0.06
0.55
0.10
0.04
0.25 -0.15 -0.02
Bill
Return
0.03
0.03
0.03
Transcribed Image Text:1. You are trying to plan your investments for the next year. You have decided that the market will either be strong (a bull market), weak (a bear market) or normal. You think that stocks, bonds, and bills will earn the following returns in these scenarios: Probability Scenario Bull market Normal market Bear market Stock Bond Return Return 0.20 0.25 0.06 0.55 0.10 0.04 0.25 -0.15 -0.02 Bill Return 0.03 0.03 0.03
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Follow-up Question

Is the equation for volatility not Σ P ( x -  )^2 ?

And I am finding online that covariance is cov(x,y) = ∑(xi - x̄)(yi - ȳ) / N - 1 , I see the equation you have given does not divide by the samples, why is this?

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Follow-up Question

For part B, is it meant to be the expected return on the stock in all market conditions or should I be using the expected return depending on the market?

e.g. instead of using 0.07 for each of the stocks, using 0.05, 0.06 and (0.04)

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