# Question: There are two stock markets each driven by the same

There are two stock markets, each driven by the same common force, F, with an expected value of zero and standard deviation of 10 percent. There are many securities in each market; thus, you can invest in as many stocks as you wish. Due to restrictions, however, you can invest in only one of the two markets. The expected return on every security in both markets is 10 percent.

The returns for each security, i, in the first market are generated by the relationship:

R1i = .10 + 1.5 F + ε1i

where ε1i is the term that measures the surprises in the returns of Stock i in Market 1. These surprises are normally distributed; their mean is zero. The returns on Security j in the second market are generated by the relationship:

R2i = .10 + .5 F + ε2j

where ε2j is the term that measures the surprises in the returns of Stock j in Market 2. These surprises are normally distributed; their mean is zero. The standard deviation of ε1i and ε2i for any two stocks, i and j, is 20 percent.

a. If the correlation between the surprises in the returns of any two stocks in the first market is zero, and if the correlation between the surprises in the returns of any two stocks in the second market is zero, in which market would a risk-averse person prefer to invest?

b. If the correlation between ε1i and ε1j in the first market is .9 and the correlation between ε2i and ε2j in the second market is zero, in which market would a risk-averse person prefer to invest?

c. If the correlation between ε1i and ε1j in the first market is zero and the correlation between ε2i and ε2j in the second market is .5, in which market would a risk-averse person prefer to invest?

d. In general, what is the relationship between the correlations of the disturbances in the two markets that would make a risk-averse person equally willing to invest in either of the two markets?

The returns for each security, i, in the first market are generated by the relationship:

R1i = .10 + 1.5 F + ε1i

where ε1i is the term that measures the surprises in the returns of Stock i in Market 1. These surprises are normally distributed; their mean is zero. The returns on Security j in the second market are generated by the relationship:

R2i = .10 + .5 F + ε2j

where ε2j is the term that measures the surprises in the returns of Stock j in Market 2. These surprises are normally distributed; their mean is zero. The standard deviation of ε1i and ε2i for any two stocks, i and j, is 20 percent.

a. If the correlation between the surprises in the returns of any two stocks in the first market is zero, and if the correlation between the surprises in the returns of any two stocks in the second market is zero, in which market would a risk-averse person prefer to invest?

b. If the correlation between ε1i and ε1j in the first market is .9 and the correlation between ε2i and ε2j in the second market is zero, in which market would a risk-averse person prefer to invest?

c. If the correlation between ε1i and ε1j in the first market is zero and the correlation between ε2i and ε2j in the second market is .5, in which market would a risk-averse person prefer to invest?

d. In general, what is the relationship between the correlations of the disturbances in the two markets that would make a risk-averse person equally willing to invest in either of the two markets?

## Answer to relevant Questions

Assume that the following market model adequately describes the return-generating behavior of risky assets: Rit = αi + βi RMt + εitHere: Rit = The return on the ith asset at Time t. RMt = The return on a portfolio ...Shanken Corp. issued a 30-year, 6.2 percent semiannual bond 7 years ago. The bond currently sells for 108 percent of its face value. The company’s tax rate is 35 percent. a. What is the pretax cost of debt? b. What is the ...An all-equity firm is considering the following projects:The T-bill rate is 3.5 percent, and the expected return on the market is 11 percent. a. Which projects have a higher expected return than the firm’s 11 percent cost ...You have recently been hired by Goff Computer, Inc. (GCI), in the finance area. GCI was founded eight years ago by Chris Goff and currently operates 74 stores in the Southeast. GCI is privately owned by Chris and his family ...Delta, United, and American Airlines announced purchases of planes on July 18 (7/18), February 12 (2/12), and October 7 (10/7), respectively. Given the following information, calculate the cumulative abnormal return (CAR) ...Post your question