1. Part A. Suppose the index model is estimated using excess returns with the following results: RA = 3% + .7RM + eA s2eA = 6% s2M = 16% RB = -2.0% + 1.2RM + eB s2eB = 9%

(a) For each stock, calculate the total variance and the systematic variance.

(b) What is the covariance between each stock and the market index? What is the correlation between each stock and the market index?

(c) What is the covariance and correlation between the two stocks?

Part B.

Refer back to the information in Question Part A. Suppose we construct a portfolio P that has 60% in A and 40% in B. Find the portfolio variance, beta, systematic variance, portfolio-specific variance and the covariance of the portfolio with the index.

Part C

Refer back to the information in Question Part B. Suppose we construct a portfolio X that has 50% in P, 30% in the market index and 20% in the risk-free asset. Find the portfolio variance, beta, systematic variance, portfolio-specific variance and the covariance of the portfolio with the index.