Murphy, who has retired for several years, is considering investing in two stocks: A and B. The returns and other related estimates for the two stocks under different states of the world in the coming year are estimated as follows:

Rate of Return if State Occurs

State of the World Probability Stock A Stock B

Good 0.1 40% -6%

Normal 0.7 24% 18%

Bad 0.2 -14% 30%

Variables Stock A Stock B

Expected Return --- 18%

Standard Deviation --- 9.3%

Beta 1 0.75

(a) Calculate the expected rate of return and standard deviation of Stock A.

(b) If Murphy could only invest in either Stock A or Stock B, which asset should he choose? Explain

(c) Assume that the covariance between Stock A and Stock B is -0.01055842 or -105.5842%^2 . Compute the expected return and standard deviation of returns of Portfolio AB in which 40% of its value is invested in Stock A and the remainder in Stock B.

(d) If Murphy could choose to invest in between Stock A, Stock B and the Portfolio AB, which should he invest in? Explain.

(e) Assume the risk-free rate is 4% and the market risk premium is 19.5%. Based on CAPM, should Murphy invest in the Portfolio AB?

Answer rating: 100% (QA)

a The expected rate of return for Stock A is 18 and the standard deviation is approximately 1669 b B... View the full answer