QUESTION TWO RISK AND RETURN

1. Refer to the following table.

		Rate of Return (%)	Rate of Return (%)
State of economy	Probability of Occurring	Firm A	Firm B
Boom	25%	5%	7%
Normal	55%	10%	9%
Recession	20%	13%	10%

1. What are the expected returns of firm A and firm B?

2. What are the standard deviations of firm A and firm B?

3. What are the coefficient of variations (CV) of firm A and firm B respectively? Which investment should you select and why?

2. You own a portfolio consisting of the following stocks.

Stock	Percentage of portfolio (%)	Beta	Expected Return (%)
A	20	1	15
B	30	0.85	13
C	50	1.20	10

The risk free is 6 percent. Also the expected return on the market portfolio is 15 percent. The expected return for the portfolio is 12.2 percent.

1. Calculate the portfolio beta.
2. Draw the security market line and show where the securities fit on the graph. State which stock is a fair value, undervalued and overvalued.

(Hint: the security market line is a positively sloped straight line displaying the relationship between expected return and beta)