Question: You are responsible for managing a portfolio of two investments for the coming year. You have read all of the latest financial news and according to your favourite reputable financial analysts, the probability of another recession occurring is 30% and the probability of a boom is 20%; otherwise the economy will be behaving normally.
Shares of Firm A are expected to earn a return of 15% during boom times, but lose 10% during a recession. Normally, the firm's common shares would earn a 10% return. The price of Firm B's shares is expected to decline 10% during boom times, but increase by 15% during a recession. Normally the firm's common shares would also earn a 10% return.
Perform a financial analysis for the purpose of calculating your expected investment return. *Please show your work/provide the complete solution to the best of your ability for your answer*
a) What is the standard deviation of expected returns for Firm A?
b) What is the standard deviation of expected returns for Firm B?
c) What is the standard deviation of expected returns for a portfolio 30% invested in shares of Firm A and the remainder in shares of Firm B?
d) Compare the return versus risk of a portfolio 100% invested in Firm A's shares with the return versus risk of the portfolio consisting of 30% invested in Firm A and 70% in Firm B. Which would you prefer? Why?