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Scenario Analysis. Consider the following scenario analysis:

Rate of Return
Scenario Probability Stocks Bonds

Recession
.20 -5% +14%

Normal economy
.60 +15 +8

Boom
.20 +25 +4

a. Is it reasonable to assume that Treasury bonds will provide higher returns in recessions than in booms?

b. Calculate the expected rate of return and standard deviation for each investment.

c. Which investment would you prefer?

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Solution Summary

The solution explains how to calculate expected returns and standard deviatio given the probability distribution.

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a. Yes, it is reasonable. Fixed income securities would provide a higher return during recession. During recession, the corporate earnings would fall and therefore the stock prioces would fall and the returns would be low. The fixed income securities would continue to provide the fixed interest. Also during the recession, more investors prefer fixed income securities and therefore the price would go up, thus providing higher return.

b. The expected rate of return of stocks can be calculated as:

ER = (Prob. of Recession)*(Return on ...

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