Question

Suppose that in 2019 the Federal Reserve Bank can take three actions with equal probability: 1) not increasing short-term interest; 2) increasing short-term interest rate moderately; 3) increasing short-term interest rate aggressively. Further assume that the returns on the stock market will be 10%, 8%, and 3% respectively in these three scenarios, and the returns on the bond market will be 4%, 6%, and 8% in these three scenarios. Suppose that you can only invest in either the stock market or the bond market and your goal is to minimize your risk (hint: standard deviation). Will you invest in stocks or bonds? 4.

Answer 1

For minimizng risk, we compare the standard deviations of the returns from stocks and bonds.

Action	Returns on stock market	Returns on bonds
1	10%	4%
2	8%	6%
3	3%	8%
STd Deviation	3.61%	2.00%

The std deviation of returns on bonds is lower and so the investment should be made in bonds.

WORKINGS