Certified Management Accountant Practice Exam

How is the covariance of a two-stock portfolio calculated?

1. Standard deviation of stock A + standard deviation of stock B

2. Correlation coefficient x standard deviation of stock A x standard deviation of stock B

3. Average return of stock A + average return of stock B

4. Total risk of stock A + total risk of stock B

The correct answer is: Correlation coefficient x standard deviation of stock A x standard deviation of stock B

The covariance of a two-stock portfolio is determined by assessing how the returns of the two stocks move together. The formula for calculating the covariance takes into account the relationship between the returns of the two stocks through their correlation coefficient, as well as the individual risks associated with each stock, which are measured by their standard deviations. The correct approach for calculating covariance uses the correlation coefficient of the two stocks, which measures the degree to which the two stocks move in relation to each other. By multiplying the correlation coefficient by the standard deviation of stock A and the standard deviation of stock B, you effectively quantify how the returns of stock A and stock B deviate from their respective means and how they relate to one another. This method gives a meaningful measure of the joint variability of the two stocks. The other options do not accurately capture the way covariance is calculated: - Summing the standard deviations does not account for how the stocks interact, which is critical for determining covariance. - Adding the average returns overlooks the needed measure of variability and correlation between the investments. - Evaluating the total risk without considering the relationship between both portfolios fails to provide insight into how the price movements relate to one another. Thus, the formulation involving the correlation coefficient and standard deviations is key to correctly