Question

The index model has been estimated for stocks A and B with the following results:

RA = 0.12 + 0.675RM + eA
RB = 0.04 + 1.520RM + eB
σM = 0.335
σ(eA) = 0.20
σ(eB) = 0.10
What is the covariance between each stock and the market index?

Answer 1

The covariance between each stock and the market index can be calculated using the beta coefficients and standard deviation of the market index.

Step-by-step explanation:

The covariance between each stock and the market index can be calculated using the formula:

Cov(A, M) = βAσ(M)

Cov(B, M) = βBσ(M)

where Cov(A, M) is the covariance between stock A and the market index, Cov(B, M) is the covariance between stock B and the market index, βA is the beta coefficient for stock A, βB is the beta coefficient for stock B, and σ(M) is the standard deviation of the market index.

Substituting the given values:

Cov(A, M) = (0.675)(0.335) = 0.226

Cov(B, M) = (1.520)(0.335) = 0.509

Therefore, the covariance between stock A and the market index is 0.226 and the covariance between stock B and the market index is 0.509.