Stock A is expected to return 12 percent in a normal economy and lose 7 percent...

Stock A is expected to return 12 percent in a normal economy and lose 7 percent in a recession. Stock B is

expected to return 8 percent in a normal economy and 2 percent in a recession. The probability of the economy

being normal is 80 percent and the probability of a recession is 20 percent. What is the covariance of these two

securities?

Please SHOW Work Not JUST ExCell Thank You

Solutions

Expert Solution

Stock A

State of Economy	Probability (P)	Return(%)	*ProbabilityReturn**	Deviation form expected return (D1)
Recession	0.2	-7	-1.40	-15.20
Normal	0.8	12	9.60	3.80

Expected return = Probability*Return

= -1.4+9.6

= 8.20%

*Deviation form expected return = Rate of return - expected return

Stock B

State of Economy	Probability (P)	Return(%)	*ProbabilityReturn**	Deviation form expected return (D2)
Recession	0.2	2	0.40	-4.80
Normal	0.8	8	6.40	1.20

Expected return = Probability*Return

= .4+6.4

= 6.80%

*Deviation form expected return = Rate of return - expected return

Probability (P)	Deviation (D1)	Deviation (D2)	PD1D2
0.2	-15.20	-4.80	14.59
0.8	3.80	1.20	3.65

Covariance = PD1D2

= 14.59+3.65

= 18.24

jeff jeffy answered 1 year ago

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