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CMA Final · Strategic Financial Management · Portfolio Theory and Practice

Two securities A and B have standard deviations of 10% and 20% respectively, and the covariance between their returns is 0.01 (that is, 100 in percentage-squared terms). What is the correlation coefficient between A and B?

The correlation coefficient is 0.50. Correlation equals covariance divided by the product of the two standard deviations, so 0.01 divided by (0.10 times 0.20) equals 0.01 divided by 0.02, which is 0.5.

  1. A0.25
  2. B0.50Correct
  3. C0.05
  4. D1.00

Explanation

Correlation = Covariance / (σA x σB). In decimals, 0.01 / (0.10 x 0.20) = 0.01 / 0.02 = 0.50. Using percentage-squared, 100 / (10 x 20) = 0.5 as well. The 0.25 option wrongly divides by the sum of the variances' scale or misuses the product.

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