Consider the probability distribution of alternative rates of return associated with stock A and B given in the following. State of economy…
BBS Fundamentals of Financial Management · 2079 · Solved Question with Answer
Consider the probability distribution of alternative rates of return associated with stock A and B given in the following.
| State of economy | Probability | Stock A | Stock B |
| 1 | 0.3 | -20% | 5% |
| 2 | 0.3 | 30% | 25% |
| 3 | 0.4 | 40 | 30 |
a. Calculate the expected return and standard deviation of Stock A and Stock B.
b. What are the covariance and correlation coefficient between Stock A and Stock B?
c. If you form a portfolio of Stock A and Stock B comprising 70 percent wealth in Stock A and the rest in Stock B, calculate the risk and return of your portfolio. Are you able to diversify the risk forming the portfolio?
d. Covariance between stock B and market is 140 and standard deviation of market is 9 percent. If risk free rate is 6 percent and market risk premium is also 4 percent, calculate required rate of return on stock B. Is stock B overpriced or underpriced?