REVIEW QUESTIONS SET 2 (EC 219)

1. Prove the three covariance rules.

2. Prove the four variance rules.
3. If Y = b1 + b2Z, where b1 and b2 are constants and Z is a variable; prove that Cov(X,Y) =
b2Cov(X,Z).
4. In a large bureaucracy the annual salary of each individual, Y, is determined by the formula
Y = 10,000 + 500S + 200T
where S is the number of years of schooling of the individual and T is the length of time, in
years, of employment. X is the individual’s age.

a) Calculate Cov(X, Y), Cov(X, S), and Cov(X, T) for the sample of five individuals shown above
and verify that Cov(X, Y) = 500Cov(X, S) + 200Cov(X, T). Explain analytically why this should
be the case.

b) Calculate Var(Y), Var(S), Var(T), and Cov(S, T) and verify that

Var(Y) = 250,000 Var(X) + 40,000 Var(T) + 200,000 Cov(S, T). Explain analytically why this
should be the case.

5. In a certain country the tax paid by a firm, T, is determined by the rule

T = –1.2 + 0.2P – 0.1I

where P is profits and I is investment, the third term being the effect of an investment incentive.
S is sales. All variables are measured in $ million at annual rates.
a) Calculate Cov(S, T), Cov(S, P), and Cov(S, I) for the sample of four firms shown below and
verify that Cov(S, T) = 0.2Cov(S, P) – 0.1Cov(S, I). Explain analytically why this should be the
case.

b) Calculate Var(T), Var(P), Var(I) and Cov(P, I), and verify that
Var(T) = 0.04Var(P) + 0.01Var(I) – 0.04Cov(P, I). Explain analytically why this should be the
case.

6. Suppose that the observations on two variables X and Y lie on a straight line Y = b1 + b2X.
Demonstrate that Cov(X, Y) = b2Var(X) and that Var(Y) = b22 Var(X), and hence that the sample
correlation coefficient is equal to 1 if the slope of the line is positive, –1 if it is negative.

7. Suppose that a variable Y is defined by the exact linear relationship Y = b1 + b2X and suppose
that a sample of observations has been obtained for X, Y, and a third variable, Z. Show that the
sample correlation coefficient for Y and Z must be the same as that for X and Z, if b2 is positive.

8. Why is covariance not a good measure of association as compared to correlation coefficient?