RISK AND RETURN

EX1

The rate of return on the common stock of Flowers by Flo is expected to be 15 percent in a boom

economy, 7 percent in a normal economy, and only 3 percent in a recessionary economy. The

probabilities of these economic states are 20 percent for a boom, 70 percent for a normal economy, and

10 percent for a recession. What is the standard deviation of the returns this stock?

EX2

KNF stock is quite cyclical. In a boom economy, the stock is expected to return 30 percent in comparison

to 12 percent in a normal economy and a negative 17 percent in a recessionary period. The probability

of a recession is 25%. There is a 15% chance of a boom economy. What is the standard deviation of the

returns this stock?

EX3

Following William Sharpe (2007)1, we have the following data for the US stockmarket, the stockmarket

is comprised:

62.0% equity stocks, 31.0% bonds and 7.0% in cash,

with the following estimates:

cash provides an annualized risk-free return, rf = 5.0%,

bonds have an expected annualized expected return, E(RB) = 6.4%,

with annualized standard deviation, B = 5.6%,

and that

equity stocks have an expected annualized return, E(RE) = 10.96%,

with annualized standard deviation, E = 17.5%,

with

1
William Sharpe shared the 1990 Nobel Prize in Economics.
correlation between equity stocks and bond returns, 𝐶𝑂𝑅𝑅(𝑅𝐸 , 𝑅𝐵 ) = 0.65.

Required:

PART A

Calculate for the following year,

(a) the expected return on a portfolio that is invested 65.0% in stocks and 35.0% in bonds.

(b) the standard deviation of the above portfolio.