Consider the following scenario analysis:

Consider the following scenario analysis:

		Rate of Return
Scenario	Probability	Stocks		Bonds
Recession	.40	−4	%	+19	%
Normal economy	.50	+20		+9
Boom	.10	+26		+8

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

b.	Calculate the expected rate of return and standard deviation for each investment. (Do not round intermediate calculations. Round your answers to 1 decimal place.)

	Expected Rate of Return	Standard Deviation
Stocks	%	%
Bonds	%	%

c.	Which investment would you prefer?
	Stocks

Explanation:

a. 

Interest rates tend to fall at the outset of a recession and rise during boom periods. Because bond prices move inversely with interest rates, bonds provide higher returns during recessions when interest rates fall.

b.

rstock = [0.40 × (−4%)] + (0.50 × 20%) + (0.10 × 26%) = 11.0%

rbonds = (0.40 × 19%) + (0.50 × 9%) + (0.10 × 8%) = 12.9%

Variance (stocks) = [0.40 × (−4 − 11.0)2] + [0.50 × (20 − 11.0)2] + [0.10 × (26 − 11.0)2] = 153.00

Standard deviation = = 12.4%

Variance (bonds) = [0.40 × (19 − 12.9)2] + [0.50 × (9 − 12.90)2] + [0.10 × (8 − 12.9)2] = 24.89

Standard deviation = = 5.0%

c.

Stocks have both higher expected return and higher volatility. More risk-averse investors will choose bonds, while those who are less risk-averse might choose stocks.