Question

Suppose that you want to hold a stock portfolio for just one year. You have $1000 to invest in stocks,

and you can choose to invest in Topgunner, Inc., which has returns of 20% in good years and –10% in bad years,

or in Lowrunner, Inc., which has returns of 35% in good years and –15% in bad years.

1. What is your return in a good year if you buy just Topgunner? In a bad year? What is your return in a good year if you buy just Lowrunner? In a bad year?

2. Now suppose that, for every stock you buy, you must pay transactions costs equal to $50.

Repeat 4.1. with your return reduced by these transactions costs. What happens to your portfolio choice?

Answer 1

Answer)

1. Topgunner gives 20% return in 1 year if it is a good year,so on $1,000 we will get 0.20*$1,000=$200 as a return,in a bad year,return is -10% which is $1,000*-0 10=-$100,similarly in good year if we buy lowrunner we get $1,000*0.35=$350 and in bad year we get return on lowrunner which is -15% that is $1,000*-0.15=-$150
2. Now we have to add $50 in every case as transaction cost which gives us $150 return on Topgunner in good year and -$150 in bad year,for lowrunner it is $300 return in good year and -$200 in bad year,in terms of portfolio choice that limits our ability to invest imn more than 1 stock as transaction costs will eat a lot of our capital.

Answer is complete. Thank you!