5-26E

a.

From information given, the variance of percent return in investment in stock 1 is

Var ( x)  25 . It is required to find the standard deviation for an investment in stock 1.

The standard deviation is square root of variance. Therefore, standard deviation is as

follows:

 x  25
= 5%

Similarly, the standard deviation for percent return on investment in stock 2 is as follows:

y  1
= 1%

Therefore, the required answers are 5% and 1% respectively. Smaller the standard
deviation, lesser the risk. Thus, investing in stock 2 is less risky.

The variance for x and y are as follows:

Var ( x)  0.2  50  37   0.5  30  37   0.3  40  37 

2 2 2

= 61
Var ( y )  0.2  80  59   0.5  50  59   0.3  60  59 
2 2 2

= 129

Therefore, the required answers are 61 and 129 respectively.

.

b.

It is required to find the expected return and standard deviation for a person who invests
$500 in stock 1.

In general multiplying a random variable by a constant multiplies the mean by that

constant and the variance by square of the constant. Therefore, expected return is as
follows:

E  x   500  8.45 
= $4225

Therefore, the required answer is: $4225 .

The standard deviation of return is as follows:

Var  x   5002  25 
= 6250000
SD  x   6250000
= 2500

Therefore, the required answer is: $2550 .

c.

It is required to find the expected return for someone who invests 50% in each stock.
Expected value of linear combination of random variables x and y is as follows:

E (ax  by )  aE ( x)  bE ( y ) (1)

From information given,

E ( x)  8.45, E ( y )  3.20

Substitute the values in the equation 1 and obtain the required return. The required return
is as follows:

E (0.5 x  0.5 y )  0.5 E ( x)  0.5 E ( y )

= 0.5  8.45 +0.5  3.20 
= 5.825

Therefore, the required answer is: 5.825% .

d.

It is required to find the expected return for someone who invests 70% in stock 1 and
30% in stock 2. Expected value of linear combination of random variables x and y is as
follows:

E (ax  by )  aE ( x)  bE ( y ) (1)
From information given,

E ( x)  8.45, E ( y )  3.20

Substitute the values in the equation 1 and obtain the required return. The required return
is as follows:

E (0.7 x  0.3 y )  0.7 E ( x)  0.3E ( y )

= 0.7  8.45 +0.3  3.20 
= 6.875

Therefore, the required answer is: 6.875% .

e.

The correlation between random variables x and y is as follows:

 xy
 xy  (2)
 x y

Where,  xy is covariance between variables x and y;  x is standard deviation for stock 1,

and  y is standard deviation for stock 2 respectively. It is required to find the correlation
coefficient for x and y.

From information given,

 xy  3,  x  5,  y  1

Substitute the values in equation (2) and obtain the correlation coefficient. The required
correlation coefficient is as follows:

 xy
 xy 
 x y
3
=
 51
= -0.6

Therefore, the required answer is: 0.6 . The negative sign of correlation coefficient
indicates that there exists negative relationship between variables x and y. In other words,
there is negative relationship between the returns of the other two stocks.