The factor model based market variance and the covariance of two markets has me confused. If anybody wants to rephrase it into simple language, it would be greatly appreciated…Thanks.
Instead of thinking of it as a market, think of it as a portfolio. It’s just that whereas the weights of the assets and their covariance drive the portfolio variance, it’s the betas of the markets and the covariance between the risk factors that determine the variance of the market. I’m not sure if that helps you?