Adequate information:
Market risk premium (MRP) =7.5%
Risk-free rate (R f) =4%
Probability of recession (PR) = 0.15
Probability of normal state (PN) =0.55
Probability of irrational exuberance (PIE) =0.30
Rate of return of Stock 1 in normal state (R1N) =0.17
Rate of return of Stock 1 in irrational exuberance (R1IE) =0.06
Rate of return of Stock 2 in recession (R2R) =-0.35
Rate of return of Stock 2 in normal state (R2N) =0.12
Rate of return of Stock 2 in irrational exuberance (R2IE) =0.33
To determine: Stock with more systematic risk, a stock with more unsystematic risk, and the riskier stock.
Introduction: The risk associated with any stock depends upon the standard deviation and expected return generated by the respective stock.
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