Portfolio Covariance Calculation Examples Help

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Portfolio Covariance Calculation Examples

Covariance is a statistical technique which establishes directional relationship between the asset prices. The asset generally moves in two directions. One is positive direction and the other is negative direction. A positive covariance reflects positive direction which means the asset prices are moving in same direction. A negative covariance reflects negative direction which the asset prices are moving in opposite direction. Covariance technique is used to reduce the overall risk for a portfolio. The covariance of two assets is calculated by the following formula step by step.
First average daily return of two assets is calculated then average daily return is subtracted from daily return. Then the outcome is multiplied with each other. Then the result is divided by the sample size and subtract one.

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Portfolio Covariance Calculation Examples Explanation

To understand the concept let’s take an example and calculate the covariance.
Daily returns of asset A Daily returns of asset X
1.0 2
1.4 1.7
2.1 4.1
0.2 3
Average return of A= (1.0+1.4+2.1+.2)/4 = 1.18
Average return of X= (2+1.7+4.1+3)/4 = 2.70
Covariance will be calculated as follows
[(1.0-1.18) x (2-2.70)] + [(1.4-1.18) x (1.7-2.70)] + [(2.1-1.18) x (4.1-2.70)] + [(0.2-1.18) x (3-2.70)]
= 0.126 – 0.22 – 1.29 – 0.98 = – 2.364/ 4-1 = – 0.788
This shows negative covariance between the two assets
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