Question

Consider two risky securities with returns K1 and K2 given by

Scenario Probability K1 K2

w(1) 0.5 10% 7%

w(2)   0.5 12% 10%

Calculate Cov(K1;K2) and Cov(k1; k2).

Answer 1

Probability	Return of stock K1	Product =Prob.*Return	Return deviation	Probability	Return of stock k2	Product =Prob.*Return	Return deviation	Ret. Dev of A*Ret. Dev of B*Prob.
			(Return - E(R))				(Return - E(R))
0.5	10%	5.0000%	-1.0000%	0.5	7%	3.5000%	-1.5000%	0.0075%
0.5	12%	6.0000%	1.0000%	0.5	10%	5.0000%	1.5000%	0.0075%
	E(R)	11.0000%			E(R)	8.5000%		0.0150%

Covariance formula = sum of( (Return deviation of A)*(Return deviation of B)*Probability)

So, Covariance of K1 and K2 as above calculation is 0.0150%