Suppose there are Only Three Possible Economic Outcomes

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Question 3 (20 marks) Suppose there are only three possible economic outcomes in the next period: boom, normal, and recession. You observe the following information about two stocks: State Probability Return on Stock A Return on Stock B Boom 0.10 18.0% 6.0% Normal 0.60 8.0% 12.0% Recession 0.30 2.0% 16.0% Required: (a) Determine the expected return and the standard deviation of return for each stock (8 marks) (4 marks) (b) Suppose you are considering an investment in a portfolio consisting of 25% of Stock A and 75% of Stock B. Determine the expected return and the standard deviation of return for the portfolio. (c) (8 marks) Critically discuss how come Stock B has a higher expected return but a lower standard deviation of return as compared to Stock A in an efficient market. (word limit: 150 words)

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