Question

Consider the following table:

   

		Stock Fund	Bond Fund
Scenario	Probability	Rate of Return	Rate of Return
Severe recession	0.05	−36%	−11%
Mild recession	0.20	−12%	13%
Normal growth	0.40	15%	4%
Boom	0.35	32%	5%

Calculate the value of the covariance between the stock and bond funds. Do not round intermediate calculations. Enter a decimal number rounded to 5 decimal places

Covariance?

Answer 1

Expected return of fund E(r) =   p(s)*r(s),

where p(s) is the probability of each scenario,

and r(s) is the expected return of each scenario.

Covariance = p(s) * (E(r)_bond - r(s)_bond) * (E(r)_stock - r(s)_stock)

Covariance = -0.00016