Question

Use the rate-of-return data for the stock and bond funds presented in Spreadsheet 6.1, but now assume that the probability of each scenario is as follows: severe recession: .10; mild recession: .20; normal growth: .35; boom: .35. (LO 6-2) 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? b. Calculate the new values of mean return and variance for the stock fund using a for- mat similar to Spreadsheet 6.2. Confirm your intuition from part (a). c. Calculate the new value of the covariance between the stock and bond funds using a format similar to Spreadsheet 6.4. Explain intuitively why the absolute value of the covariance has changed.

Answer 1

a)

The rate of return of stock for each scenario has different probabilities. The probabilities for each scenario has changed. The mean return and variance of the stock will be changed due to change in probabilities. By observing the probability ans stock returns, it can be said that the expected return and variance will be higher. The reason to this; the severe recession scenario has higher probability compared to the previous probabilities.

b)

The Standard deviation = 21.32.

This shows an increase which was discussed in part a)

c)

The new convergence is -42.93

The convergence changed to -42.93 because the severe recession scenario and in boom scenario has higher stock returns. Therefore, in the calculation of mean, more weightage is of these returns and so their deviation from mean is notable.

Step-by-step explanation: