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covariance
Portfolio: a combination of
securities
The return on a portfolio P in state j
RPj xi Rij
i 1
RPj
x
i 1
Rij x1 R1 j x2 R2 j
Asset 2
Asset 3
Good
1.16%
1.01%
Average
1.10%
1.10%
1.10% = .6*(1.10)+.4*(1.10)
Poor
1.04%
1.19%
RPj xi Rij
i 1
i 1
i 1
i 1
-thus the expected return on a portfolio is a weighted average of the means of the
individual assets
Expectation Operator
let a, b and c be constants
let R1 and R2 be random variables
J
E[ R1 ] P1 j R1 j
j
E[ R2 ] P2 j R2 j
j
R3
Mean
1.10%
1.10 %
Variance
.0024
.0054
Rpj
PPj
Good
1.10%
Average
1.10%
Poor
1.10%
V [ RP ] P2 E[ RP E ( RP )]2
2 2
x
i i
i 1
x xi x j ij
2
P
i 1
2
i
2
i
i 1 j 1
i j
P2 xi2 i2 xi x j ij
i 1
i 1 j 1
i j
P2 xi2 i2 xi x j ij
i 1
i 1 j 1
i j
P2 xi2 i2 xi x j ij
i 1
i 1 j 1
i j
x xi x j ij
2
P
i 1
2
i
2
i
i 1 j 1
i j
x xi x j ij
2
P
i 1
2
i
2
i
i 1 j 1
i j
x xi x j ij
2
P
i 1
2
i
2
i
i 1 j 1
i j
it should be clear that the formula for the variance can also be written as:
N
P2 xi x j ij
i 1 j 1
eg. let N 2
P2 x1 x1 1,1 x1 x2 1, 2 x2 x1 2,1 x2 x2 2, 2
x12 12 2 x1 x2 1, 2 x22 22
because 1,1 12 , 2, 2 22 , 1, 2 2,1
V (a ) 0
V (aR ) a 2 V ( R)
V ( R1 R2 ) V ( R1 ) V ( R2 ) 2Cov( R1 , R2 )
V ( R1 R2 ) V ( R1 ) V ( R2 ) 2Cov( R1 , R2 )
COVARIANCE
the covariance is a measure of the linear relationship between two
random variables:
Cov ( RA , RB ) A, B E [( RA E ( RA )) ( RB E ( RB ))]
M
Ps [ R A s E ( RA )][ RB s E ( RB )]
s
Covariance (cont)
If all M outcomes are equally likely then Ps = 1/M
for all s and:
A, B
(R
s 1
As
R A )( RBs R B )
-for a sample
s A, B
M
1
( R As R A )( RBs RB )
M 1 s 1
Covariance(RA , RB)
-if the covariance is positive it signifies that when RA is above its mean
E(RA ), then RB is also above its mean E(RB)
i.e. asset A and B move together in a positive linear fashion
-if the covariance is negative it signifies that when RA is above its mean E(RA ),
then RB is BELOW its mean or
when RA is below its mean E(RA ), then RB is ABOVE its mean
i.e. asset A and B move together in a negative linear manner
Positive Covariance
RA
RB
Negative Covariance
RA
RB
RAj
PAj
RBj
PBj
4.1
1/7
5.8
1/7
2.3
1/7
2.3
1/7
1.6
1/7
1.6
1/7
-.18
1/7
-3.72
1/7
3.7
1/7
4.3
1/7
1.6
1/7
1.6
1/7
4.8
1/7
6.04
1/7
RBs
PS
[RAs
- E (R
)] [RBs
4.1
5.8
1/7
[4.1
2.3
2.3
1/7
[2.3
1.6
1.6
1/7
[1.6
-.18
-3.72
1/7
3.7
4.3
1/7
[3.7
1.6
1.6
1/7
[1.6
4.8
6.04
1/7
[4.8
4.840914286
SUM
- E (R
) ] PS
A, B
A B
1 A, B 1
2abCov ( R1 , R2 )
2
1
2
2
a 2 12 b 2 22 2ab1, 2 1 2
Cov(R1 , R 2 )
1 2
Covariance or Correlation
Operator
Cov (a, R ) 0
(a, R1 ) 0
(aR1 , R2 ) ( R1 , R2 )
(aR1 , bR2 ) ( R1 , R2 )
Copyright information
Slides prepared by and the property of
Marie Racine. Copyright Racine Marie,
2016