Question

How do I calculate the covariance between 2 risky assets?

Answer 1

Create a table (Excel?) that displays the daily returns for the two assets over some period of time.

Explanation:

It is easiest to provide an example. The table below shows two assets (A and B). I created random daily returns for each asset.

Here is the formula for Covariance:

Covariance `=(sum(R_(Ai)-Mean_A)xx(R_(Bi)-Mean_B))/(n-1)`

It looks ominous , but it is actually quite simple. In the table below I calculated the mean (or average) return over 10 days. This mean value is `Mean_A and Mean_B`.

Next, subtract these mean values from the respective returns for each day (see table below).

Finally, multiply the results from above for each day, add it up and divide by 9 (10 days minus 1). This is the covariance and equals 0.033 for this example.

That's it!

In the example there is a positive covariance , so the two assets tend to move together. When one has a high return, the other tends to have a high return as well. If the result was negative , then the two stocks would tend to have opposite returns; when one had a positive return, the other would have a negative return.

A zero covariance may indicate that the two assets are independent .

Read more: Calculating Covariance For Stocks http://www.investopedia.com/articles/financial-theory/11/calculating-covariance.asp#ixzz3ro4B2qTQ
Follow us: Investopedia on Facebook