Module 52.2: Covariance and Correlation

Question 1

What is the formula for sample variance?

What is the formula for standard deviation?

Answer 1

(Rt - Raverage)^2 / (T - 1)

Standard deviation = square root of sample variance

Question 2

What is the formula for covariance? what does it imply?

Answer 2

Covariance = (Rt1 - Raverage1 ) * (Rt2 - Raverage2) / (n -1)

Covariance measures how two variables move together over time.

Question 3

What is the formula for correlation?

Answer 3

Cov1,2 / standard deviation 1 * standard deviation of 2

or

Cov1,2 = p1 * standard deviation 1 * standard deviation 2

p1 = correlation coefficient

Question 4

What does a correlation coefficient of -1, +1, and zero imply?

Answer 4

+1 = always proportional in the same direction

-1 = always proportional in the opposite direction

0 = no linear relationship between the two stocks’ returns.