Question

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 -0.01
4. 0.02 0.15
5. -0.02 -0.06
6. 0.05 0.02

Instruction

a. Average monthly rate of return for each stock

b. Standard deviation of returns for each stock

c. Covariance between the rates of return

d. The correlation coefficient between the rates of return

e. Would these two stocks be good choices for diversification? Why or why not?

Answer 1

solve in EXCEL

The diversification advantage increases as the covariance decreases.

The first paper has a lower covariance, therefore, it should be limited in the portfolio.