20 May 2015
DEFINITION of 'Covariance' A measure of the degree to which returns on two risky assets move in tandem. A positive covariance means that asset returns move together. A negative covariance means returns move inversely.
One method of calculating covariance is by looking at return surprises (deviations from expected return) in each scenario. Another method is to multiply the correlation between the two variables by the standard deviation of each variable.
INVESTOPEDIA EXPLAINS 'Covariance' Possessing financial assets that provide returns and have a high covariance with each other will not provide very much diversification.
For example, if stock A's return is high whenever stock B's return is high and the same can be said for low returns, then these stocks are said to have a positive covariance. If an investor wants a portfolio whose assets have diversified earnings, he or she should pick financial assets that have low covariance to each other.
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20 May 2015
Correlation The correlation coefficient is the relative measure of the relationship between two assets. It is between +1 and -1, with a +1 indicating that the two assets move completely together and a -1 indicating that the two assets move in opposite directions from each other.
Formula 17.8
Example: Calculate the correlation of Asset A with Asset B. Given our covariance of 18 in the example above, what is the correlation coefficient for Asset A relative to Asset B if Asset A has a standard deviation of 4 and Asset B has a standard deviation of 3.
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