Suppose that you are considering investing in two stocks for one year: Stock A and Stock B

Suppose that you are considering investing in two stocks for one year: Stock A and Stock B. The current price of stock A is $60 and analysts forecast a price of $80 in one year if the economy is booming, or $50 if the economy enters a recession. The current price of Stock B is $30 and analysts forecast a price of $36 in one year if the economy is booming and a price of $32 if the economy is in a recession. You believe that the probability of a recession is 40% and the boom is 60%. Stocks A and B do not pay dividends.

(*** SHOW your work for partial credit. Please copy the cells from a spreadsheet and paste them into the box, OR type in your calculations directly. DO NOT upload pictures of your spreadsheet or your notes. Emailing them *does not* count for partial credit.)

a) Calculate the expected return for each stock based on these forecasts and report your results. (only answers inside the box count)

b) Suppose that you decide to invest $40,000 in stock A and $160,000 in stock B. Find the expected return and standard deviation of the portfolio. (only answers inside the box count)

c) Assume that stock A has beta = 1.5 and stock B has beta=1.1. Further, the expected return on the market is 12% and the risk free is 1.5%. Calculate the expected return for both stocks if they were correctly priced (i.e., using the CAPM). (only answers inside the box count)

d) Compare the expected returns given by the analyst (that you computed in “a”) with those when you calculated in part c in order to identify if these stocks (Stock A and/or Stock B) are undervalued or overvalued and explain why. (only answers inside the box count)