Question

Use the follwoing scenario analyses for ABC Technologies Co. and XYZ Innovations Co. below. Address the question of whether these two securities have heging potential.

	Bullish Market	Bearish Market
Probability	70%	30%
Return ABC Technologies	27%	-32%
Return XYZ Technologies	12%	-7%

(prove your answer quantitatively)

Answer 1

Expected return of ABC = 0.70*27+0.30*-32

=18.9-9.6

=9.3%

Expected return of XYZ= 0.70*12-0.30*7

=8.4-2.1

=6.3%

σ² of ABC=0.70(27-9.3)²+0.30(-32-9.3)²

=219.30+511.70

σ=27.04%

σ² of XYZ=0.70(12-6.3)²+0.30(-7-6.3)²

=22.74+53.07

σ=8.71%

probability	Deviation of ABC	Deviation of XYZ	Product	Probability * product
0.7	17.7	5.7	100.89	70.62
0.3	-41.3	-13.3	549.29	164.79

Covariance=70.62+164.79

=235.41

Correlation= Covariance/27.04*8.71

=0.99

Since correlation is close to 1 two securities do not have hedging potential as securities which are negatively correlated have better hedging potential.