1 suppose that you have the following data on

Question

1. Suppose that you have the following data on states of nature and outcomes for three securities:

State                 Prob.                R_A                    R_M                   R_F

I                       0.6                   14%                 12%                 4%

II                      0.4                   -2%                  3%                   4%

1. Find the expected return and standard deviation for each security.
2. Find the covariance between A and M.  Then, find the correlation between A and M.
3. Given the correlation between A and M, is it useful to form a portfolio using these two assets?  Explain.
4. Form a portfolio by allocating 40% of your wealth to A and the remainder to M.  Compute the expected return and standard deviation of this portfolio.  Compare the standard deviation to a weighted average standard deviation for A and M.  Explain why the portfolio standard deviation is either the same as or lower than the weighted average standard deviation.

2. What is a "real option" and how does it relate to capital budgeting and the objective of the firm?