3. Correlation and Covariance

Question 1

What happens when you combine two or more securities in a portfolio?

Answer 1

The standard deviation of the portfolio’s
return will often be lower than the weighted average of the standard deviations of these individual
securities. (The weightings are given by the proportion of the portfolio held in security A and that held in
security B.)

Question 2

What is the benefit of diversification?

Answer 2

The reduction in risk for a given level of expected return

Question 3

What concepts are used to quantify the reduction is risk for a given level of expected return?

Answer 3

1) Correlation
2) Covariance

Both of these involve analysing the relationships between the movements of different assets. Do they move in line with each other, or against each other, and by what degree?

Question 4

What are Correlation and Covariance?

Answer 4

Correlation is the name given to the measure of how two asset returns may be related (or move together,
or correlate), and covariance is the measure of the strength of the correlation