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Risk and Return - Section 11.2

The document discusses calculating variance, standard deviation, covariance, and correlation for returns data using unequal probabilities. It provides an example of calculating these values for two investments, Supertech and Slowpoke, across different economic states. It also notes that while the calculations were demonstrated without built-in functions, Excel can calculate covariance and correlation for historic returns data using its COVARIANCE.P and CORRELATION functions.

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Dane Jones
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83 views99 pages

Risk and Return - Section 11.2

The document discusses calculating variance, standard deviation, covariance, and correlation for returns data using unequal probabilities. It provides an example of calculating these values for two investments, Supertech and Slowpoke, across different economic states. It also notes that while the calculations were demonstrated without built-in functions, Excel can calculate covariance and correlation for historic returns data using its COVARIANCE.P and CORRELATION functions.

Uploaded by

Dane Jones
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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We use the AVERAGE, VAR, and STDEV functions to calculate the average, variance, and standard deviation for

historical returns. Unfortunately, Excel does


built-in functions that handle unequal probabilities, so we need to create our own equations.

Supertech
(5)
(1) (2) (3) (4) Deviation from (6) (7)
State of Probability of Return if State Product Expected Return Squared Value Product
Economy State Occurs (2) × (3) (3) - E(R) of Deviation (2) × (5)
Depression 0.25 -0.20 -0.05 -0.38 0.140625 0.0351563
Recession 0.25 0.10 0.025 -0.08 0.005625 0.0014063
Normal 0.25 0.30 0.075 0.13 0.015625 0.0039063
Boom 0.25 0.50 0.125 0.33 0.105625 0.0264063
Expected return = 0.175 Variance = 0.0668750

The standard deviation is the square root of the variance, so the standard deviation is:

Standard deviation: 25.86%

And for Slowpoke:

Slowpoke
(5)
(1) (2) (3) (4) Deviation from (6) (7)
State of Probability of Return if State Product Expected Return Squared Value Product
Economy State Occurs (2) × (3) (3) - E(R) of Deviation (2) × (5)
Depression 0.25 0.05 0.0125 -0.005 0.000025 0.0000062
Recession 0.25 0.20 0.0500 0.145 0.021025 0.0052563
Normal 0.25 -0.12 -0.0300 -0.175 0.030625 0.0076563
Boom 0.25 0.09 0.0225 0.035 0.001225 0.0003063
Expected return = 0.0550 Variance = 0.0132250

Standard deviation: 11.50%

To calculate the covariance and correlation, we need to calculate the product of the return deviations, multiply this product by the probability of the state o
economy, and then sum to find the covariance. Doing so, we find:

Deviation of Deviation of
Supertech Slowpoke Probability of
Return from Return from State of the
the the Economy times
State of Probability of Expected Expected Product of the Product of the
Economy State Return Return Deviations Deviations
Depression 0.25 -0.375 -0.005 0.001875 0.000469
Recession 0.25 -0.075 0.145 -0.010875 -0.002719
Normal 0.25 0.125 -0.175 -0.021875 -0.005469
Boom 0.25 0.325 0.035 0.011375 0.002844
Covariance = -0.004875

Since the correlation is the covariance divided by the product of the standard deviations, the correlation between Supertech and Slowpoke is:

Correlation: -0.1639

Covariance and Correlation with Historic Data


While we just discussed the calculation of covariance and correlation using unequal probabilities, both calculations are often done using historic market data
using historic data, Excel has built-in functions that will calculate the covariance and correlation for you.

Suppose we have the following returns for the market and a stock:

Year Market return Stock return


1 18% 7%
2 27% 25%
3 5% 21%
4 13% 4%
5 -17% -16%
6 6% 19%
7 -21% -38%
8 34% 29%
9 19% 15%
10 11% 16%

What is the covariance and correlation of the returns between this stock and the market?

Covariance: ( 0.0281)
Correlation: ( 0.8648)
. Unfortunately, Excel does not have
he probability of the state of the

Slowpoke is:

ne using historic market data. When

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