The following table lists possible rates of return on Company A and B.

State of Economy	Probability	Company A	Company B
Deep recession	0.05	-20%	-40%
Mild recession	0.25	0	10
Average	0.35	10	0
Mild boom	0.20	15	25
Strong boom	0.15	30	30

(a) Based on the above data calculate by using the appropriate formulae i. the standard deviations of returns for Company A and B ii. the covariance of returns between Company A and B iii. the correlation between Company A and B

(b) If you wish to diversify risk, would it be advisable to form a portfolio of both securities A and B? State your reasons. (No computations are required to answer this part of the question.)

(c) Find the minimum variance one can get by forming a portfolio of A and B. Short selling either stock is allowed – i.e., weights need not be all positive.

Answer rating: 100% (QA)

a i To calculate the standard deviation of returns for Company A and B we use the following formula Pi Ri Ravg2 where is the standard deviation Pi is the probability of state i Ri is the return in sta... View the full answer