Suppose that the index model for stock A and B is estimated from the excess returns with the following results.

Note: Significance level for the coefficient is set at 90% confidence interval and that risk=standard deviation.

Stock A:

Alpha 1%

alpha P-value 1.00%

Beta 0.5

beta P-value 1.00%

firm specific risk 18%

weights in P (arbitrary) 60%

Stock B

Alpha 1.30%

alpha P-value 8.00%

Beta 0.8

beta P-value 0.00%

firm specific risk 22%

weights in P (arbitrary) 40%

Market risk 18%

Market expected return 5%

1. What are the expected excess returns for stock A and B, given that the market expected excess return of 5%?
2. What is the total risk for each stock?
3. If you were to take an active position, which stock would you choose, A or B? Why?
4. What is the covariance between each stock and the market index and between the two stocks?
5. For Portfolio P with investment proportions of 0.6 in A and 0.4 in B, what is the covariance of portfolio P with the market index?