Question 3

Make the necessary assumptions to solve this question. Be sure to answer all sub questions. Explain your calculations, support your answers and state in detail any relevant assumptions required.

Suppose you observe the following situation in Table 2 where the returns on stocks C and D vary depending on the state of the economy:

Table 2 Returns on stocks C and D under different states of the economy

State of the Economy	Probability of economic state occurring	Return on C if economic state occurs	Return on D if economic state occurs
Recession*	0.20	0.08	0.12
Normal	0.65	0.11	0.12
Rapid economic growth or boom	0.15	0.30	0.36

* e.g. Interpretation of line 1 in Table 2: There is a probability of 20% of occurring a recession and in those circumstances stocks C and D would have a return of -0.08 and -0.12 respectively.

What is the expected return on stocks C and D? Consider that Stock Ds beta exceeds Stock Cs beta by 0.16 and that the Capital Asset Pricing Model (CAPM) holds. What is the expected market risk premium? Explain which stock is riskier.

In addition, identify in which state of economy (Recession, Normal or Boom

- in the first column of table 2) do you find the United States of America at the end of 2021? Explain why, providing evidence. (Use a maximum of 200 words).