Suppose the index model for stocks A and B is estimated with the following results: rA = 2% + 0.8RM + eA, rB = 2% + 1.2RM + eB, σM = 20%, and RM = rM − rf . The regression R2 of stocks A and B is 0.40 and 0.30, respectively. Answer the following questions. Total: (a) What is the variance of each stock? (b) What is the firm-specific risk of each stock? (c) What is the covariance between the two stocks?
Risk and return
Before understanding the concept of Risk and Return in Financial Management, understanding the two-concept Risk and return individually is necessary.
Capital Asset Pricing Model
Capital asset pricing model, also known as CAPM, shows the relationship between the expected return of the investment and the market at risk. This concept is basically used particularly in the case of stocks or shares. It is also used across finance for pricing assets that have higher risk identity and for evaluating the expected returns for the assets given the risk of those assets and also the cost of capital.
Suppose the index model for stocks A and B is estimated with the following results:
rA = 2% + 0.8RM + eA, rB = 2% + 1.2RM + eB, σM = 20%, and RM = rM − rf . The regression
R2 of stocks A and B is 0.40 and 0.30, respectively. Answer the following questions. Total:
(a) What is the variance of each stock?
(b) What is the firm-specific risk of each stock?
(c) What is the covariance between the two stocks?
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