Question 4.47

4.47 A random walk on Wall Street?

The “random walk” theory of securities prices holds that price movements in disjoint time periods are independent of each other. Suppose that we record only whether the price is up or down each year and that the probability that our portfolio rises in price in any one year is 0.65. (This probability is approximately correct for a portfolio containing equal dollar amounts of all common stocks listed on the New York Stock Exchange.)

194

  1. What is the probability that our portfolio goes up for three consecutive years?
  2. If you know that the portfolio has risen in price two years in a row, what probability do you assign to the event that it will go down next year?
  3. What is the probability that the portfolio's value moves in the same direction in both of the next two years?

4.47

(a) 0.2746. (b) 0.35. (c) 0.545.