Covariance

It is a measure of the degree to which returns on two risky assets move in tandem. In other words, it is a measure of how two variables move together. Generally, covariance is used to determine rates of return, which are expressed in percentages.

Positive covariance - asset returns move together or in the same direction. Negative covariance asset returns move inversely or in opposite directions. Zero covariance the two assets/variables are indifferent.

Formula:

Covariance =
Where r = asset return rave = average return N = sample size

(r1-r1ave)(r2-r2ave) N-1

Note: If the given is an entire population, then you could just divide by the population size.

For example: Day 1 2 3 4 5 ABC Returns (%) XYZ Returns (%) 1.1 1.7 2.1 1.4 0.2 3 4.2 4.9 4.1 2.5

Solution:
Day ABC Returns (%) -r1 1.1 1.7 2.1 1.4 0.2 1.3 XYZ Returns (%) r2 3 4.2 4.9 4.1 2.5 3.74 Step 2 (r1r1ave) -0.2 0.4 0.8 0.1 -1.1 Step 3 (r2-r2ave) -0.74 0.46 1.16 0.36 -1.24 TOTAL Step 4 (r1-r1ave)(r2r2ave) 0.148 0.184 0.928 0.036 1.364 2.66

1 2 3 4 5 Average

Step 5 Covariance = 2.66 / (5-1) = 0.665

In this situation, we are using a sample, so we divide by the sample size (five) minus one.

Meaning
In the example, there is a positive covariance so the two stocks tend to move together. When one has a high return, the other tends to have a high return as well. If the result was negative, then the two stocks would tend to have opposite returns; when one had a positive return, the other would have a negative return.

Conclusion
Covariance is a common statistical calculation which can show how two stocks tend to move together. We can only use historical returns so there will never be complete certainty about the future. Also, it should not be used on its own. Instead, it can be used in other, more important, calculations such as correlation, or standard deviation.

Shortcut Formula: Covariance = 1 N-1

x y

x y N