Question

Stock ABC has variance of daily returns 0.0001 and market beta 0.9. Stock XYZ has variance of daily returns 0.0004 and market beta of 1.3. The variance of the market portfolio daily returns is 0.00025. Fill out the variance-covariance matrix for ABC and XYZ using the market model.

Answer 1

Market Model refers to capital asset pricing model and as per this model two stocks are not related to each other in terms of unsystematic risk. They are related to each other only by the way of systematic risk ie due to market portfolio both exhibit certain relationship which is captured as under -

Covariance between stock ABC and XYZ = Beta of ABC * Beta of XYZ * Market variance =.9*1.3*.00025=.0002925

So variance -covariance matrix look like as under-

ABC to ABC (variance)=.0001

XYZ to XYZ (variance)=.0004

ABC to XYZ or XYZ to ABC (co-variance)=.0002925