a) Calculate the expected rate of return for each stock respectively. Explain what the expected value implies. b) Calculate the standard deviation for each stock respectively. Explain what the standard deviation implies. c) If you were an investor in which stock you were going to invest? Justify your answer.
Continuous Probability Distributions
Probability distributions are of two types, which are continuous probability distributions and discrete probability distributions. A continuous probability distribution contains an infinite number of values. For example, if time is infinite: you could count from 0 to a trillion seconds, billion seconds, so on indefinitely. A discrete probability distribution consists of only a countable set of possible values.
Normal Distribution
Suppose we had to design a bathroom weighing scale, how would we decide what should be the range of the weighing machine? Would we take the highest recorded human weight in history and use that as the upper limit for our weighing scale? This may not be a great idea as the sensitivity of the scale would get reduced if the range is too large. At the same time, if we keep the upper limit too low, it may not be usable for a large percentage of the population!
![The following table represents the rate of returns of two stocks in different
economic conditions along with their probabilities (the data are also uploaded on
moodle)
RATES OF RETURN ON STOCKS
EXPECTED
ЕCONOMIC
PROBABILITY
STOCK A
STOCK B
CONDITIONS
RECESSION
0.55
-0.04
-0.02
STABLE
0.35
0.25
0.30
EXPANDING
0.10
0.15
0.20
Answer the following by using mathematical calculations:
a) Calculate the expected rate of return for each stock respectively. Explain
what the expected value implies.
b) Calculate the standard deviation for each stock respectively. Explain what
the standard deviation implies.
c) If you were an investor in which stock you were going to invest? Justify
your answer.
d) Calculate the covariance between Stock A and stock B. Discuss.
e) Calculate the expected return and the standard deviation of the portfolio
consisting 40% in stock A and 60% in stock B.
1) Discuss the risk and return associated with investing
i. All of your funds in stock A
ii. All of your funds in stock B
40% of your funds in stock A and 60% of your funds in StockI
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