Covariance

Reviewed by Bhavana | Updated on Aug 27, 2020

Introduction

Covariance calculates the directional relationship between two assets' returns. A positive covariance means that the returns of assets move together while a negative covariance means that they move in the opposite direction.

Covariance is determined either by evaluating anomalies at the return (standard deviations from the expected return) or by multiplying the association between the two variables (standard deviation of each variable).

Covariance is a statistical method used to assess the relationship between two asset pricing movements. These are seen as having a positive covariance when two stocks tend to move together. When they move in the opposite direction, the covariance is negative.

In the modern portfolio theory, a covariance is an important tool used to evaluate what securities bring into a portfolio. By combining assets that have a negative covariance, risk and uncertainty can be reduced in a portfolio.

Understanding Covariance

Covariance assesses how two variables' mean values shift together. The returns of stock A grows higher whenever the returns of stock B grows higher. On similar lines, the return of stock A may decrease depending on the dip in stock B. In this case, these stocks are said to have positive covariance. Covariances are measured in finance to assist in the diversification of defense assets.

While the covariance evaluates the directional relationship between two assets, it doesn't display the strength of a relationship between the two assets. The correlation coefficient is an indicator of this strength that is more appropriate.

Possessing financial assets with returns having similar covariances does not provide much diversification. Therefore, a diversified portfolio will likely contain a mixture of financial assets with varying covariances.

Covariances have significant financial and conventional portfolio theory applications. For instance, the covariance between security and the market is used in the calculation for one of the main variables of the model, beta, in the capital asset pricing model (CAPM). This model is used to measure the expected return of an asset.