The following are the monthly rates of return for Madison Cookies and for Sophie Electric during a six-month period. Month Madison Cookies Sophie Electric 1 -0.04 0.07 2 0.06 -0.02 3 -0.07 -0.10 4 0.12 0.15 5 -0.02 -0.06 6 0.05 0.02 Compute the following: a) Average monthly rate of return for each stock b) Standard deviation of returns for each stock c) Covariance between the rates of returns d) The correlation coefficient between the rates of return e) What level of correlation would you have expected before performing your calculations? f) How did your expectations compare with the computed correlation? g) Would these two stocks be good choices for diversification? Why or why not?
Risk and return
Before understanding the concept of Risk and Return in Financial Management, understanding the two-concept Risk and return individually is necessary.
Capital Asset Pricing Model
Capital asset pricing model, also known as CAPM, shows the relationship between the expected return of the investment and the market at risk. This concept is basically used particularly in the case of stocks or shares. It is also used across finance for pricing assets that have higher risk identity and for evaluating the expected returns for the assets given the risk of those assets and also the cost of capital.
The following are the monthly
|
Month |
Madison Cookies |
Sophie Electric |
|
1 |
-0.04 |
0.07 |
|
2 |
0.06 |
-0.02 |
|
3 |
-0.07 |
-0.10 |
|
4 |
0.12 |
0.15 |
|
5 |
-0.02 |
-0.06 |
|
6 |
0.05 |
0.02 |
Compute the following:
- a) Average monthly rate of return for each stock
- b) Standard deviation of returns for each stock
- c) Covariance between the rates of returns
- d) The correlation coefficient between the rates of return
- e) What level of correlation would you have expected before performing your calculations?
- f) How did your expectations compare with the computed correlation?
- g) Would these two stocks be good choices for diversification? Why or why not?
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