Question 2 (32 marks)

Sam has $10,000 and is considering investing in two stocks - HSCC and Ninecent. The followings are the returns of these stocks under different states of affair:

state of affair	probability	HSCC	NINECENT
pandamic	0.2	2%	16%
no pandemic (normal)	0.3	3%	10%
no pandemic (boom)	0.5	14%	5%

a) Calculate the expected rate of return, variance and standard deviation of HSCC & Ninecent. (6 marks)

b) Suppose Sam forms a portfolio with the stocks of HSCC and Ninecent. If he wants the portfolio to have 8.6% expected return, how much should he invest in HSCC? Calculate the variance and standard deviation of this portfolio given the covariance between HSCC and Ninecent is -0.0022 (or -0.22%). (8 marks)

c) Explain why the risk of Sams portfolio is lower than the weighted average risk of HSCC and Ninecent. (4 marks)

d) Suppose the risk-free rate is 3%, the market risk premium is 6% and the betas for HSCC and Ninecent are 0.7 and 1.3 respectively. Using the CAPM model, estimate the required rates of return of HSCC & Ninecent. (6 marks)

e) Should Sam buy HSCC or Ninecent? Justify your answer by checking whether the two stocks are overpriced or underpriced. (4 marks)

f) Ninecent is having higher beta while HSCC is having larger standard deviation. Explain why the results of beta and standard deviation can be different even though both of them are measuring risk. (4 marks)