1. If the returns on two stocks are highly correlated, what does this mean? If t

Question

1. If the returns on two stocks are highly correlated, what does this mean? If they have no correlation? If they are negatively correlated?

2. Why should younger investors be willing to hold a larger amount of equity in their portfolios?

3. Use the following information on states of the economy and stock returns to calculate the expected return for Dingaling Telephone:

State of Economy Probability of State Security return in State

Recession 0.20 -7.0%

Normal 0.55 12.0%

Boom 0.25 21.0%

4. Using the information in the previous question, calculate the standard deviation of Dingaling’s returns. (Note: this asks for the standard deviation of a KNOWN probability distribution.)

Explanation / Answer

1:

Highly correlated (0 < < 1) indicates the movement tendency of both stocks in same direction. Perfect correlation ( = 1) indicates both stocks move exactly together.

No correlation ( = 0) indicates both stocks are uncorrelated. Both stocks tend to move in any direction.

Negatively correlated (-1 < < 0) indicates both stocks tend to move in opposite direction.

Perfectly negatively correlation ( = -1) indicates both stocks move exactly opposite direction.

2:

More skilled with modern and sophisticated tools, younger generations can take more risk and have greater ability to modified their workflow to minimize the losses.

3:

Return = 0.20*(-7) + 0.55*(12) + 0.25*(21) = 10.45%

4:

Variance = 0.20*(-7-10.45)^2 + 0.55*(12-10.45)^2 + 0.25*(21-10.45)^2

Variance = 90.047500 = (9.489336)^2

Standard Deviation = 9.49%

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