Question

1.      Assume that there are two assets and three state of economy as follow

State Of Economy	Probability Of State Of Economy	Rate   Of Return If State Occurs
		Asset A	Asset   B
Recession	0.20	-0.15	0.20
Normal	0.50	0.20	0.30
Boom	0.30	0.60	0.40

Assume further that Br. 15,000 invested in asset A and Br. 5,000 invested in asset B. Based on this information, answer the following questions.

a)      Compute expected returns and standard deviation of the portfolio      à5Marks

b)      Compute covariance of the assets (Cov_AB)                                           à2Marks

c)      If the assets are mutually exclusive, which asset you prefer? Why?    à3Marks  

Answer 1

Probability of Boom = 1-Probability of Recession-Probability of Normal = 1-0.2-0.5 = 0.3

	Stock A
Economy	Probabilty	Return	Probability* Return	Return- Expected Return[D]	Probability*D*D
Recession	0.2	-0.15	-0.03	-0.4	0.032
Normal	0.5	0.2	0.1	-0.05	0.00125
Boom	0.3	0.6	0.18	0.35	0.03675
	Expected Return = Sum of Probabilty*Return	0.25 = 25%	Variance =Sum of [D^2]	0.07
				Standard Deviation =Variance^1/2	0.264575131 = 26.46%

	Stock B
Economy	Probabilty	Return	Probability* Return	Return- Expected Return[D]	Probability*D*D
Recession	0.2	0.2	0.04	-0.11	0.00242
Normal	0.5	0.3	0.15	-0.01	5E-05
Boom	0.3	0.4	0.12	0.09	0.00243
	Expected Return = Sum of Probabilty*Return	0.31 = 31%	Variance =Sum of [D^2]	0.0049
				Standard Deviation =Variance^1/2	0.07 = 7%