economicz

Let's work through an example:

If a firm specific event impacts asset i, the components which make up the event should be uncorrelated across components of other assets - however asset i as a whole CAN be correlated with another asset through Beta.

So, according to the market model - in order for the covariance to be correct the components should be uncorrelated - if they are then the covariance is incorrect.

If THAT is our understanding - then how do we test for the incorrectness of market model covariance in the cases where the components are in fact correlated, i.e. do we still use the market model covariance?