Question

5. You are considering investing in two stocks. There are two possible states for the economy over the next year: ‘Good’ and ‘Bad’. Each state is equally likely (that is, probability for each state is 50%). Their return in each possible state is estimated as follows:

State	Return to stock A	Return to stock B
Good	30%	5%
Bad	10%	10%

1. What are the expected return and volatility of each stock return?
2. What are the covariance and correlation between the two stock returns?
3. Suppose that a risk-free investment of 5% is also available. Does this present a profit opportunity to you? Why or why not? Explain.
4. Draw a diagram to illustrate the tradeoff between risk and return (that is available portfolios or funds) by investing in these two stocks (assume no short selling).

Answer 1