Question

Q5: What is Covariance between variables (say return between stocks over time)? (Show equation) What does this measure? What if you had high, medium or low covariance between stock returns? What does this tell you and what are the implications? Show Equation/Definition!!, answer all questions.

Answer 1

Covariance between variables represent how both variables are related to each other...Whether they have position relation or negative relation.

Postitive covariance = Variables are positively related

Negative Covariance = Variables are negative related

Example :- If stock A Increase then stock B also increase then it means they have positive Covariance.

If Sales of T shirt decrease as Winter Cold increase that means both variables have a negative covariance.

Covariance helps to find out the correlation between the variables.

If we divide the Covariance of two variable by their Standard deviation then we arrive at a Correlation of the variable.

Correlation = Covariance / Standard deviation of variables.

2) Covariance helps to determine that how two stocks are connected to each other.

High Covariance represent that if stock A increase then stock B also increases

Low Covariance represent that There is little or negative relation between two variables.

Formula of calculating Covariance

Cov(x,y) = € (X - Mean of X) (Y- Mean of Y) / ( N-1)

Covariance tell us the strength of relationship between variables.

It helps in estimation like if there is positive Covariance between A & B. If A perform well then it will be estimated then B will also perform well as checked imperically by high Covariance