Question

Calculate the covariance of the returns on Bedolf Corporation (Re) with the returns on Zedock Corporation (R), using the following data 6. Probability Function of Bedolf and Zedock Returns R-5% R.-3096 RB-15% R.-1096 R,-15% 0.25 0 0 R,-10% 0 0.50 0 0 0.25

Answer 1

First step is to find the expected returns of both stocks which can be calculated by taking the weighted averages of all 3 return values. For example the expected return on zedock corporation stock is

E (R.) = 0.25 * 0.15 + 0.50 * 0.10 + 0.25 * 0.05

or 10%

E( R.) = 0.10

Similarly,

E(RB)0.25 0.300.50 0.150.25 0.10

or 17.5%

E(Re) = 0.175

Now, the covariance is calculated as:

Covariance = 0.25(0.15-0.10)(0.30-0. 175) 0.175)0.25(0.05 -0.10) (0.10-0.175) 0.5(0.10-0.10)(0.15

Each term consists of probability multiplied by differences of each stock's return and its expected return.

By calculating the above equation, we get

Covariance0,0025