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Correlation and Covariance

Expected Value

The weighted average of the possible outcomes of a random variable, X, where the weights for each outcome is the probability that the outcome will occur. best guess of the outcome of a random variable

E ( X ) P( xi ) xi P( x1 ) x1 P( x2 ) x2 ... P( xn ) xn

Expected value of a portfolio

E ( RP ) wi E ( Ri ) w1 E ( R1 ) w2 E ( R2 ) ... wn E ( Rn )
i 1

Covariance

A measure of how two assets move together. The expected value of the product of the deviations of the two random variables from their respective expected values. The covariance of the return of assets A and B

Cov(RA , RB ) P(S ){[RA E(RA )][RB E(RB )]}

Properties of Covariance

Same concept as variance, that is, it measures how a random variable moves with another random variable. Cov(RA, RA) = Var (RA) Values ranges from negative infinity to positive infinity.

Example
Event Very Good P(S) 0.3 RA 0.2 RB 0.3

Normal Slow

0.5 0.2

0.15 0.05

0.1 0.01

Cov(RA , RB ) P(S ){[RA E(RA )][RB E(RB )]}

Correlation

Covariance can be easier interpreted using the concept of correlation (strength of linear relationship between two random variables)

Cov( RA , RB ) Corr ( RA , RB ) ( RA ) ( RB )

Variance

Variance of a Portfolio
Var ( RP ) wi w j Cov( Ri , R j )
i 1 j 1 n n

Variance of a two-asset Portfolio, A and B

2 2 2 Var( RP ) wA 2 ( RA ) wB ( RB ) 2wA wBCov( RA , RB )

Variance of a three-asset Portfolio, A, B, and C

2 2 2 Var ( RP ) wA 2 ( RA ) wB 2 ( RB ) wC 2 ( RC )

2 wA wB Cov( R A , RB ) 2 wA wC Cov( R A , RC ) 2 wB wC Cov( RB , RC )

Example

A portfolio consists of \$500 in Asset A and \$600 in Asset B. the joint probabilities of the returns of these assets are: Probability RA=0.2 RA=0.15 RA=0.04 RB=0.4 0.15 0 0 RB=0.2 0 0.60 0 RB=0.0 0 0 0.25

What are the expected value, variance and covariance of the portfolio?

Example

A portfolio of three assets with market values of \$500, \$900 and \$1,200, resp. Below are the market weight, expected return, variance and the correlation of the three assets: Correlation E(Ri) 0.1 0.12 Var(Ri) .0016 .0036 wi 0.2 0.3 RA 1.00 0.46 RB 0.46 1.00 RC 0.22 .64

Returns RA RB

RC

0.16

.01

0.5

0.22

0.64

1.00

What is the variance of the portfolio return?

Seatwork
You are considering a portfolio of three stocks: Stock A (55% of the portfolio) has an expected return of 8% with a standard dev of 24% Stock B (25% of the portfolio) has an expected return of 4% with a standard dev of 18% Stock C (20% of the portfolio) has an expected return of 3% with a standard dev of 15% The correlations between these stocks returns are: Corr(RA, RB) = .85; Corr(RA, RC) = .3; Corr(RC, RB) = -.15 1. Construct a covariance matrix for the returns of the three stocks. 2. Calculate the expected return of the portfolio and the standard deviation of the portfolio.