As the covariance of a stock's return with the market portfolio increases, its price ______, all else equal.
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A. B. C. D.C
As the covariance of a stock's return with the market portfolio increases, its betaincreases. This increases its expected return in the CAPM framework, causing its price to decline.
The correct answer is C. decreases.
Covariance measures the relationship between the returns of two assets, in this case, the stock's return and the market portfolio's return. A positive covariance indicates that the returns of the stock and the market portfolio move together, while a negative covariance suggests that their returns move in opposite directions.
When the covariance of a stock's return with the market portfolio increases, it means that the stock's return becomes more closely related to the market portfolio's return. In other words, the stock's performance becomes more dependent on the overall market conditions.
In the context of stock pricing, an increase in the covariance implies that the stock's returns are more volatile and sensitive to market movements. Investors perceive this higher risk and uncertainty associated with the stock, which leads to a decrease in its price.
The reasoning behind this is as follows: when the covariance increases, it indicates that the stock's returns tend to move in the same direction as the market portfolio's returns. During periods of market downturns, the stock is likely to experience larger declines due to its increased sensitivity to market movements. Investors require a higher expected return to compensate for this increased risk, leading to a decrease in the stock's price.
It is important to note that this relationship assumes that all else remains equal. In reality, stock prices are influenced by multiple factors, and the covariance with the market portfolio is just one of them. Other factors such as company-specific news, industry trends, and overall market sentiment can also impact stock prices.