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Expected return and risk on stocks

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An individual is considering the purchase of stocks of two firms: an auto-lube chain and a pharmaceutical corporation. Because of the uncertainty in oil prices, you estimate that there is a 50-50 chance of your either earning an 80 percent return on your investment or losing 80 percent of your investment within a year. The pharmaceutical industry is more stable, so you estimate that you have a 50-50 chance of either earning 10 percent or losing 10 percent. Suppose that both stocks have equal expected returns. Which stock would you buy? Why? What do you think other investors would do? What would be the effect of these actions on the relative prices of the two stocks?

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Solution Summary

The expected return and risk on two stocks are calculated and the better of the two stocks is identified for investment purpose.

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An individual is considering the purchase of stocks of two firms: an auto-lube chain and a pharmaceutical corporation. Because of the uncertainty in oil prices, you estimate that there is a 50-50 chance of your either earning an 80 percent return on your investment or losing 80 percent of your investment within a year. The pharmaceutical industry is more stable, so you estimate that you have a 50-50 chance of either earning 10 percent or losing 10 percent. Suppose that both stocks have equal expected returns. Which stock would you buy? Why? What do you think other investors would do? What would be the effect of these actions on the relative prices of the two ...

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