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CFA Level I · CFA Level I Exam · Statistical Characteristics of Asset Returns

An analyst computes the sample covariance between the monthly returns of two equity funds and obtains a value of 0.0042. Which statement about this result is most accurate?

A positive covariance means the two funds' returns tend to move together in the same direction. Its magnitude depends on the scale of the returns and is unbounded, so it is hard to interpret strength from covariance alone; correlation is better for that.

  1. AIt shows the two funds tend to move in the same direction, but its size is hard to interpretCorrect
  2. BIt shows a strong linear relationship because the value is close to zero
  3. CIt shows the funds move in opposite directions because covariance is a squared term

Explanation

A positive covariance indicates the returns tend to move in the same direction. Covariance is unbounded and depends on the units and scale of the returns, so its magnitude says little about strength. A value near zero would not indicate a strong relationship, and covariance is not a squared term, so it can be negative or positive.

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