Question

Question No. 3:                                                                                 (15marks)

Consider the following two companies and their forecasted returns for the upcoming year:

		Company A	Company B
Outcome 1	Probability	100%	50%
	Return	8%	12.5%
Outcome 2	Probability	-	50%
	Return	-	5.5%

1. What is the standard deviation of the returns on each company's stock (Company A, and B) (write all formulas) (12 marks).
2. Of these two stocks, which is riskier? Justify your answer (3 marks).

	Company A	Company B
Re
σ

Company ……………. is riskier because………………………………………………………… …………………………................................................................................................................................................................................................................................................................................

Answer 1

Answer : Expected Return of Stock A = Sum of (Expected Return * Probability)

= [8% * 1]

= 8%

Expected Return of Stock B = Sum of (Expected Return * Probability)

= [12.5% * 0.50] + [5.5% * 0.50]

= 9%

Standard Deviation of Stock A = Sum of (Square of Deviation from expected Return * Probability)

= [(8% - 8%) * 1]

= 0

Standard Deviation of Stock B = Sum of (Square of Deviation from expected Return * Probability)

= [(12.5% - 9%)^2 * 0.50] + [(5.5% - 9%)^2 * 0.50]

= [12.25 * 50] + [12.25 * 0.50]

= 6.125% + 6.125%

= 12.25%

Company B is riskier because if the standard deviation is high we can interepret that values are widely deviated from its mean Standard deviation indicator of volatility(risk). The more unpredictable the price movements and the more will be the standard deviation and ,the greater the risk