Question

QUESTION 4

You are considering investing either of the three stocks- A, B and C. The following table provides the information regarding the stocks

	Returns (in percent)
Probability	Stock A	Stock B	Stock C
0.20	2	-3	5
0.50	10	8	8
?	15	20	12

Based on the above information

1. Calculate the expected rate of returns and variance for each of the three stocks?

                                                                                                              

2. Calculate the coefficient of variation for each security?                                   

c) Your friend suggests you to purchase Stock A because the stock provides the highest return as compared to other stocks. If you are a risk averse investor, which stock should you choose? Justify your answer.                                                                                          (1 mark)                                                                                                                       

Answer 1

a. Probability in scenario 3 =1-0.20-0.50 =0.30

Expected Return of A =0.20*2%+0.50*10%+0.30*15% =9.90%
Expected Return of B =0.20*-3%+0.50*8%+0.30*20% =9.40%
Expected Return of C =0.20*5%+0.50*8%+0.30*12% =8.60%

Variance of A =0.20*(2%-9.90%)^2+0.50*(10%-9.90%)^2+0.30*(15%-9.90%)^2=0.002029
Variance of B =0.20*(-3%-9.40%)^2+0.50*(8%-9.40%)^2+0.30*(20%-9.40%)^2=0.006544
Variance of C =0.20*(5%-8.60%)^2+0.50*(8%-8.60%)^2+0.30*(12%-8.60%)^2=0.000624

b. Coefficient of Variation of A =Variance of A ^0.5/Expected Return of A =0.002029^0.5/9.90% =0.4550
Coefficient of Variation of B =Variance of B ^0.5/Expected Return of B =0.006544^0.5/9.40% =0.8606
Coefficient of Variation of C =Variance of C ^0.5/Expected Return of C =0.000624^0.5/8.60% =0.2905

c. Stock C should be chosen as coefficient of C is lowest hence risk is least in stock C .