Investment Textbook Solution

In: Business and Management

Submitted By shark8281
Words 3703
Pages 15
Chapter 6
Q.7
Use the rate-of-return data for the stock and bond funds presented in Spreadsheet 6.1, but now assume the probability of each scenario is as follows: severe recession: 0.10; mild recession: 0.20; normal growth:0.35; boom: 0.35.

(a) Would you expect the mean return and variance of the stock fund to be more than, less than, or equal to the values computed in Spreadsheet 6.2? Why?

The variance is expected to increase because the probabilities of the extreme outcomes are now higher.
The mean return would be probably similar to the original one.

(b) Calculate the new values of mean return and variance for the stock fund using a format similar to Spreadsheet 6.2. Confirm your intuition from part (a) | A | B | C | D | E | F | G | 1 | Scenario | Probability | Rate of Return | Col. B X Col. C | Deviation from Expected Return | Squared Deviation | Col. B X Col. F | 2 | Severe recession | 0.10 | -37 | -3.7 | -46.5 | 2162.25 | 216.225 | 3 | Mild recession | 0.20 | -11 | -2.2 | -20.5 | 420.25 | 84.05 | 4 | Normal growth | 0.35 | 14 | 4.9 | 4.5 | 20.25 | 7.0875 | 5 | Boom | 0.35 | 30 | 10.5 | 20.5 | 420.25 | 147.0875 | 6 | | Expected Return = | 9.5 | Variance = Sum | 454.45 | 7 | | | Standard Deviation = SQRT (Variance) | 21.3178 |

(c) Calculate the new value of the covariance between the stock and bond funds using a format similar to Spreadsheet 6.4. Explain intuitively the change in the covariance. | A | B | C | D | E | F | 1 | | | Deviation from Mean Return | Covariance | 2 | Scenario | Probability | Stock Fund | Bond Fund | Product of Dev | Col. B X Col. E | 3 | Severe recession | 0.1 | -46.5 | -12.15 | 564.975 | 56.4975 | 4 | Mild recession | 0.2 | -20.5 | 11.85 | -242.925 | -48.585 | 5 | Normal growth | 0.35 | 4.5 | 4.85 | 21.825 | 7.63875 | 6 | Boom | 0.35 | 20.5 | -8.15 | -167.075 | -58.47625 | 7 | | |…...

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