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Problem: The probability that the economy will experience a recession next year is 0.3, while the probabilities of moderate growth or rapid expansion are 0.5 and 0.2, respectively. The stock of Firm A is expected to return 5%, 15%, or 20%, depending on whether the economy experiences a recession, moderate growth or rapid expansion, respectively. The returns for Firm B are expected to be 0%, 16% or 30%, respectively.
Required:
Question 1: Calculate the expected returns for each firm's common stock.
Question 2: What is the variance to the return for Firm A and B common stock?
Question 3: What is the standard deviation of the rate of return for firm A and B common stock?
Question 4: According to CAPM, the expected return on a risky asset depends on three components. Describe each component, and explain its role in determining expected return.
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