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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(%) Probability*Return 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(%) Probability*Return 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 2 years ago
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