Practice Question
The return on stock A has a covariance of 0.1 with the return on the market portfolio whereas the return on stock B has covariance of 0.3 with the market return. The return on which stock moves more closely with the return on the market portfolio?
To determine which stock moves more closely with the return on the market portfolio, we need to calculate the beta for each stock.
The formula for beta is:
\[
\beta_i = \frac{\text{Cov}(R_i, R_m)}{\text{Var}(R_m)}
\]
where \( \text{Cov}(R_i, R_m) \) is the covariance of the stock with the market and \( \text{Var}(R_m) \) is the variance of the market returns.
Given:
- Cov(RA, Rm) = 0.1
- Cov(RB, Rm) = 0.3
- Var(Rm) = unknown
Without the market variance, we cannot compute beta for either stock. Beta is the correct measure of co-movement, not raw covariance. Therefore, we lack the required information.
Conclusion: The correct answer is:
Insufficient information: we would need the standard deviation of both A and B.