QUESTION 1: The index model has been estimated for stocks A and B with the following results:
RA = 0.01 + 0.65RM+ eA
RB = 0.02 + 1.75RM+ eB
The standard deviation of the market index is 25%; the residual standard deviation of the error terms for stock A is 20%; the residual standard deviation of the error terms for stock B is 10%. What is the covariance between the returns on stocks A and B?
QUESTION 2: Using the data from problem 1, what is your best estimate of the total variance of the excess returns on stock B? Enter your answer rounded to two decimal places. Do not enter % in the answer box. For example, if your answer is 0.12345 or 12.345% then enter as 12.35 in the answer box.
QUESTION 3: Using the data from problem 1, what is your best estimate of the R-Squared in the regression of stock A on the market index M? Enter your answer as a decimal rounded to four decimal places. Do not enter % in the answer box. For example, if your answer is 0.12345 or 12.345% then enter as 0.1235 in the answer box.
QUESTION 4: Suppose you held a well-diversified portfolio with a very large number of securities, and that the single index model holds. If the standard deviation of your portfolio was 35% and the standard deviation of the market was 15%, what would be your estimate of the beta of the portfolio? Hint: Note that a well-diversified portfolio will have a firm-specific variance and a residual standard deviation = 0%.