1. Explain Covariance and Correlation in Asset Allocation with Two Risky Assets. 2. Explain the Mean-Variance...

1. Explain Covariance and Correlation in Asset Allocation with Two Risky Assets.

2. Explain the Mean-Variance Criterion.

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Expert Solution

1) Covariance is a statistical measure used to measure how returns of 2 assets move in relation to each other. Covariance providess diversification and reduces the overall volatility of the portfolio. A positive covariance signifies that the assets are moving in the same direction. Conversely, a negative covaiance signifies that assets are moving in opposite direction. If the two assets have a negative correlation, this reduces the overall risk level of the portfolio. Covariance does show the direction of relation between the assets, but for direction as well as strength of the relationship between the prices, correlation is used. Correlation standardizes covariance, and is defined as Covariance/(standard deviation of Stock 1*standard deviation of Stock 2)

2) The mean-covariance criterion states that in a multiple asset portfolio, the weights of the assets are to be decided in such a manner to maximise the expected return ie. mean to variance of the portfolio ratio. This is based on the premise that the weights should be such that it maximises the return for a given level of risk of the portfolio.

jeff jeffy answered 2 years ago

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