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solution

In this problem, Stocks 1 and 2 are two stocks, not necessarily in the Stock_FX_Bond_2004_to_2005.csv data set. Suppose that Stock 1 has betas of 0.5, 0.4, and −0.1 with respect to the three factors in the Fama–French model and a residual variance of 23.0. Suppose also that Stock 2 has betas of 0.6, 0.15, and 0.7 with respect to the three factors and a residual variance of 37.0. Regardless of your answer to Problem 9, when doing this problem, assume that the three factors do account for all covariances.

(a) Use the Fama–French model to estimate the variance of the excess return on Stock 1.

(b) Use the Fama–French model to estimate the variance of the excess return on Stock 2.

(c) Use the Fama–French model to estimate the covariance between the excess returns on Stock 1 and Stock 2.

Solution:

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