CA Final · Advanced Financial Management · Portfolio Management
An analyst at Iyer Capital estimates the covariance between the returns of Stock P and Stock Q as 48 (in %-squared units). The standard deviations are 8% for P and 10% for Q. What is the correlation coefficient between P and Q?
The correlation coefficient is 0.60. It equals the covariance divided by the product of the two standard deviations, so 48 divided by 8 times 10, which is 48 divided by 80. Correlation must lie between -1 and +1.
- A0.60Correct
- B0.48
- C6.00
- D0.75
Explanation
Correlation = Covariance / (sigma P x sigma Q) = 48 / (8 x 10) = 48/80 = 0.60. The 0.75 option divides by 64, using only sigma P squared. The 0.48 option wrongly divides by 100. A correlation value cannot exceed 1, so 6.00 is not possible.
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