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Assuming you have invested only in two stocks, A and B
Assuming you have invested only in two stocks, A and B. The returns on the two stocks depend on the following three states of economy, which are equally likely to happen: TABLEQ2b: Returns of Stock A and Stock B State of Economy Return on Stock A (%) Return on Stock B (%) Bear 6.30 (3.70) Normal 10.50 6.40 Bull 15.60 25.30 Discuss the characteristics of the two stocks in TABLEQ2b above and propose the stock (either Stock A or Stock B) that offers greater returns using any of the risk-return tradeoff models or methods.
Expert Solution
| Return on Stock A | Return on Stock B | |
| Bear | 6.30% | -3.70% |
| Normal | 10.50% | 6.40% |
| Bull | 15.60% | 25.30% |
Expected Return of Stock A = (6.30 + 10.50 + 15.60)/3 = 10.80%
Expected Return of Stock B = (-3.70 + 6.40 + 25.30)/3 = 9.33%
Standard Deviation of Stock A = [{(6.30-10.80)^2 + (10.50-10.80)^2 + (15.60-10.80)^2}/3]^0.5 = 3.80%
Standard Deviation of Stock A = [{(-3.70-9.33)^2 + (6.40-9.33)^2 + (25.30-9.33)^2}/3]^0.5 = 12.02%
Since, the expected return of stock A is greater than expected return of stock B while the volatility in stock A is lesser than stock B, any rational investor should invest in Stock A. Stock A will provide higher risk adjusted return than stock B.
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