Reference no: EM132589762

1: Consider the simple two-period model. Let today be period zero and tomorrow be period 1. Assume that today's price of AAA stock is $23 and tomorrow price could be $28 or $21 with equal probabilities. Answer the following questions:

a. What is the expected rate of return on AAA stock?

b. What is the risk of AAA stock?

c. Assume that you want to allocate your initial wealth of $1,000 on a portfolio that consists of AAA stock and of BBB stock, with equal weights to each stock. If BBB stock is currently traded at $24 has an expected rate of return of 4 percent, variance of 900 and covariance between the two stocks is 25. Find the expected rate of return on this portfolio and its risk.

2: You want to invest in a portfolio that consists of two stocks: AAA and BBB. According to your analysis, you are expecting three states of nature: recession, steady and expansion, with probabilities of 0.2, 0.5 and 0.3 respectively. Current AAA stock price is $50, while BBB stock is $40. The following table show the analysts' prediction for the price in each state: State of Economy Probability AAA stock BBB STOCK Recession 0.2 $51 $41 Steady 0.5 $54 $42 Expansion 0.3 $58 $47 Suppose you decided to construct a portfolio, ??, such that 60% of your wealth is allocated to AAA stock and 40% to BBB stock. Given this allocation, solve the following two questions:

a. Compute the expected rate of return on ??.

b. Compute the portfolio's measure of risk.