QUESTION SEVEN

A. Briefly explain what is meant by a conditional probability. [3 Marks]

B. The following data was collected in relation to interest rates and investment returns. As an investor, you are keep to determine the degree. If any, of relationship between the two.

4

Interest Rate Fluctuations (%)

Returns on investments (%)

16

22

13

26

20

14

40

5

Required:

i. Calculate the Covariance of the two variables. [5 marks]

ii. Calculate the Correlation Coefficient of the two variables. [7 marks]

C. An investment offers the following expectations:

35% chance of receiving K15,000

35% chance of receiving K19,000

30% chance of receiving K30,000

This investment provides the option of accepting a guaranteed K25,000 cash inflow with a risk-adjusted rate of 15% and a risk free rate of 5%.

Required:

i. Compute the certainty equivalent cash flow. [4 marks]

ii. Which option should a risk averse investor opt for and why? [2 marks]

D. Assume that the following list represents the continuous distribution of returns for a particular investment.

5.2%, 12.2%, 15%, 20%, 6%, 11.3%, -8%, -20%

Required:

Calculate the standard deviation for the above returns assuming a continuous distribution. [4 marks]