Stock A is expected to return 14 percent in a normal economy and lose 21 percent in a recession. Stock B is expected to return 11 percent in a normal economy and 5 percent in a recession. The probability of the economy being normal is 75 percent with a 25 percent probability of a recession. What is the covariance of these two securities?a) 0.007006b) 0.006563c) 0.005180d) 0.007309e) 0.006274

The correct option is b) 0.006563.

Explanation:

Note: See the attached excel file for the calculation of the covariance between stocks A and B.

Covariance refers to a metric that measures the relationship between two random variables by showing the degree to which the two variables change together.

A positive covariance means that two variables move in the same direction, while a negative covariance indicates that the two variables tend to move in the opposite directions.

In the attached excel file, the following are used:

RA = Rate of Return of Stock A

RB = Rate of Return of Stock B

P = Probability

ERA = Expected return of Stock A = RA * P

ERB = Expected return of Stock B = RB * P

DA = Deviation of Stock A = RA - Sum of ERA

DB = Deviation of Stock B = RB - Sum of ERB

N = Number of observation = 2

Therefore, Covariance of Stock A and B is calculated using the covariance formula as follows:

Covariance of Stock A and B = Sum of (DA * DB) / N = 1.3125% / 2 = 0.6563%, or 0.006563

Therefore, the covariance of these two securities is 0.006563. This shows that the correct option is b) 0.006563.

in terms of experimental research, mcdonald’s charging different prices in the two cities relates to

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