Suppose you are considering investing in two different stocks, A and B, with the following characteristics:

• Stock A has an expected return of 8% and a standard deviation of 12%.
• Stock B has an expected return of 10% and a standard deviation of 15%.

You have a risk aversion coefficient of 2, which means you require a risk premium of 2% for every 1% increase in standard deviation. In addition, you have an anchoring bias, which causes you to anchor on the initial price of the stock when making investment decisions.

a) Calculate the risk premium required for investing in stock A and stock B.

b) Assuming the current prices of stock A and stock B are $50 and $100, respectively, and you believe they are both undervalued by 10%, which stock should you invest in according to your anchoring bias?

c) Calculate the expected return of the stock you chose in part (b) and determine if it is sufficient to compensate for the risk you are taking.

Answer rating: 100% (QA)

The detailed answer for the above question is provided below a The risk premium required for investing in stock A and stock B can be calculated using ... View the full answer