Question

Explain the importance of covariance and correlation between assets and understanding the expected value, variance, and standard deviation of a random variable and of returns on a portfolio.

Answer 1

Covariance and Correlation between assets are highly important because they are used for diversification in a Portfolio to a large extent as they will be reflecting the relation between rate of return of one stock in respect to rate of return of another stock so there is a focus upon selecting of those stocks whose rate of return are not matching with each other and they are not replicating each other so there could be an opportunity of maximizing the rate of return through proper diversification because if all these negatively correlated stocks and low correlated stocks are added to the portfolio then it will provide the portfolio with a high degree of diversification and it could only be established through covariance and correlation which has also been implicated in the modern portfolio theory by Harry markowitz.

covariance and correlation will be reflected through the relationship of rate of return between two Assets and it will try to find the derivation of the rate of return between two asset also so it will overall provide a wide spectrum of relationship between two asset so can there could be a possibility of maximizing upon high rate of return by diversification to the maximum extent through looking for unrelated stocks.