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# Covariance of stock returns, Diversification

Problem: # 1. As a new analyst, you have calculated the following annual rates of return for both Lauren Corporation and Kayleigh Industries.

Year Lauren's Rate of Return Kayleigh's Rate of Return

1996 5 5

1997 12 15

1998 -11 5

1999 10 7

2000 12 -10

Your manager suggests that because these companies produce similar products, you should continue your analysis by computing their covariance. Show all calculations.

Problem: # 2. You decide to go an extra step by calculating the coefficient of correlation using the data provided in Problem 1. Prepare a table showing your calculations and explain how to interpret the results. Would the combination of Lauren and Kayleigh be good for diversification? Explain how to interpret the results. Would the combination of Lauren and Kayleigh be good for diversification?
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I need help to solve some problems from book Corporate Investment Analysis - in FINANCE. Book from: Reilly, F. & brown, K. (2009). Investment Analysis and Portfolio Management (9th ed.). Mason, OH: South-Western/ Cengage Learning. Book used by Strayer University. I need help to solve those Appendix problems: 1, and 2

#### Solution Preview

Problem: # 1. As a new analyst, you have calculated the following annual rates of return for both Lauren Corporation and Kayleigh Industries.

Year Lauren's Rate of Return (X) Kayleigh's Rate of Return (Y)
-4.64
1996 5 5
1997 12 15
1998 -11 5
1999 10 7
2000 12 -10

Your manager suggests that because these companies produce similar products, you should continue your analysis by computing their covariance. Show all calculations.

X Y (X-Xmean) (Y-Ymean) (X-Xmean) x (Y-Ymean)
5 5 -0.6 0.6 -0.36
=5-5.6 =5-4.4 =-0.6x0.6
12 15 6.4 10.6 67.84
-11 5 -16.6 0.6 -9.96
10 7 4.4 2.6 11.44
12 -10 6.4 -14.4 -92.16
Total= 28 22 -23.2

N= 5
Mean of Lauren's Rate of Return (X)= 5.6 =28/5
Mean of Kayleigh's Rate of Return (Y)= 4.4 =22/5

Covariance= ...

#### Solution Summary

Questions on covariance of stock returns and effects of diversification have been answered.

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