Hey guys, I don’t know if my brain is just fried or I’m not thinking straight but I could use your help here… I don’t quite understand how they got to The volatility of SCI after adjusting for the correlation is √0.3181 = 56.4%… where did the 0.3181 come from…
If I remember this problem …
you need to use given information to arrive at the var(error term).
then use the new correlations - sum up the individual factor terms and also add the error term.
Hey Cpk, thanks for the reply 
So I still don’t get it, gaaaaah… lol here is the full answer. I understand it all up to the 0.0224 bit… but then how do they get to √0.3181 = 56.4%
Begin with:
Var (M) = Var (_F_1)× (_b_1)2 + Var (_F_2) × (_b_2)2 + 2 × _b_1 × _b_2 × Cov (_F_1, _F_2) +
Var (ε).
Find the variance of the error term using values from Exhibit 2:
0.2704 = 0.0784 × (1.020)2+ 0.1024 × (1.045)2 + 2 × 1.020 × 1.045 × 0 +
Var (ε),
Var (ε) = 0.0770.
The adjustment is stated as being a correlation of 0.25.
Change the correlation into a covariance:
Cov(F1,F2) = Corr(F1,F2) × Std Dev (F1) × Std Dev (F2)
= 0.25 × (0.0784)0.5 × (0.1024)0.5 = 0.0224
The volatility of SCI after adjusting for the correlation is √0.3181 = 56.4%
Alrighty then… I am approaching the state of being mentally handicapped as the exam date approaches… wow… lol figured it out… they plugged the 0.0224 covariance back into the original formula 0.0784 × (1.020)2+ 0.1024 × (1.045)2 + 2 × 1.020 × 1.045 × 0 + Var (ε) To get the new variance of 0.0784 × (1.020)2+ 0.1024 × (1.045)2 + 2 × 1.020 × 1.045 × 0.0224 + 0.0770 = 0.3181
*facepalm* *headesk*
Screwed question.
This is not the last equation.
Plug in covariance to calculate variance via standard formula
S2 = w1s1+w2s2+2w1w2cov1,2+ε
Then take squared root to get final solution, standard deviation, a volatility measure.
I was practicing few times still not sure that I would be able to solve without cheet sheet.
Agreed Flashback… I mean I get it now… but it’s not an exercise I’d relish on exam day, it is convoluted and cumbersome… lets hope the institute sees more value in asking other questions
A level 2 type question.Lol!
I have a basic question : can I ask you guys a question please. could you tell me why we don’t add the intercept in the equation?
I failed the same one., and agree I think there is no chance to see it on the exam… hopefully!
Intercept is in the regression equation for estimating market returns. There is no intercept in factor model based market variance formula.
I actually just did this topic test again today for my second time. This is definitely one of the most solidly hard ones and that question really makes my head spin. I understand it but I just don’t see myself remembering all these steps on exam day. I am simply not putting in the time on this one random chance question. Lets hope something this complex doesn’t show up.
I passionately hate this question 