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Covariance

 A statistical measure of the degree to which random


variables move together.
 A positive covariance means the variables are
positively related and move in the same direction,
while a negative covariance means the variables
are inversely related and move in opposite
direction
Measuring Covariance of Assets
 A measurement of the degree to which two
variables “move together” relative to their
individual mean values over time

Covij = E{[Ri - E(Ri)] [Rj - E(Rj)]}


Covariance Formula
Monthly Return Rates
for Canadian Stocks & Bonds
Monthly Return Rates
for Canadian Stocks & Bonds
Monthly Return Rates
for Canadian Stocks & Bonds

Cov (X,Y)= -11.39/12-1

Cov (X,Y)= -1.035


Interpretation
 The covariance between the returns of the S&P 500
and DEX is –1.035. Since the covariance is negative,
the variables are negatively related—they move in
the opposite direction.
Correlation
 Correlation is another way to determine how two
variables are related. In addition to telling you
whether variables are positively or inversely
related, correlation also tells you the degree to
which the variables tend to move together.
Correlation Coefficient
 Coefficient can vary in the range +1 to -1.
 Value of +1 would indicate perfect positive correlation. This
means that returns for the two assets move together in a
positively and completely linear manner.
 If correlation coefficient is zero, no relationship exists
between the variables. If one variable moves, you can make
no predictions about the movement of the other variable; they
are uncorrelated.
 Value of –1 would indicate perfect negative correlation. This
means that the returns for two assets move together in a
completely linear manner, but in opposite directions.
Covariance and Correlation
 The correlation coefficient is obtained by
standardizing (dividing) the covariance by the
product of the individual standard deviations
 Computing correlation from covariance

Cov
r    ij
ij i j
r  the correlatio n coefficien t of returns
ij
 i  the standard deviation of R it
 j  the standard deviation of R
Standard Deviation
of a Portfolio
n 2 2 n n
 port   w     w w Cov
i1 i i i1i1 i j ij

where :
 port  the standard deviation of the portfolio
Wi  the weights of the individual assets in the portfolio, where
weights are determined by the proportion of value in the portfolio
 i2  the variance of rates of return for asset i
Cov ij  the covariance between the rates of return for assets i and j,
where Cov ij  rij i j
Standard Deviation
of a Portfolio ( two stock)
 An other way to calculate variance of a
two-stock portfolio and three stock
portfolio
variance of a two-stock portfolio

Variance of two-stock portfolio is sum of four boxes



variance of a three-stock portfolio