Question

A broker has calculated the expected values of two different financial instruments X and Y. Suppose that E(x)= $100, E(y)=$90 SD(x)= 90$ and SD(y)=$8. Find each of the following.
a. E(X+ 10) and SD(X+ 10)
b. E(5Y) and SD(5Y)
c) E(X+ Y) and SD(X+ Y)
d) What assumption must you make in part c?

Answer 1

Expectation is linear, meaning

E(a X + b Y) = E(a X) + E(b Y)

= a E(X) + b E(Y)

If X = 1 and Y = 0, we see that the expectation of a constant, E(a), is equal to the constant, a.

Use this property to compute the expectations:

E(X + 10) = E(X) + E(10) = $110

E(5Y) = 5 E(Y) = $450

E(X + Y) = E(X) + E(Y) = $190

Variance has a similar property:

V(a X + b Y) = V(a X) + V(b Y) + Cov(X, Y)

= a^2 V(X) + b^2 V(Y) + Cov(X, Y)

where "Cov" denotes covariance, defined by

E[(X - E(X))(Y - E(Y))] = E(X Y) - E(X) E(Y)

Without knowing the expectation of X Y, we can't determine the covariance and thus variance of the expression a X + b Y.

However, if X and Y are independent, then E(X Y) = E(X) E(Y), which makes the covariance vanish, so that

V(a X + b Y) = a^2 V(X) + b^2 V(Y)

and this is the assumption we have to make to find the standard deviations (which is the square root of the variance).

Also, variance is defined as

V(X) = E[(X - E(X))^2] = E(X^2) - E(X)^2

and it follows from this that, if X is a constant, say a, then

V(a) = E(a^2) - E(a)^2 = a^2 - a^2 = 0

Use this property, and the assumption of independence, to compute the variances, and hence the standard deviations:

V(X + 10) = V(X)  ==>  SD(X + 10) = SD(X) = $90

V(5Y) = 5^2 V(Y) = 25 V(Y)  ==>  SD(5Y) = 5 SD(Y) = $40

V(X + Y) = V(X) + V(Y)  ==>  SD(X + Y) = √[SD(X)^2 + SD(Y)^2] = √8164 ≈ $90.35