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FRM Part I · FRM Exam Part I · Measuring Return, Volatility, and Correlation

Asset X has an annualized volatility of 20% and Asset Y has an annualized volatility of 30%. Their correlation is 0.60. What is the covariance of their annual returns?

Covariance equals correlation times the product of the two standard deviations. With 0.60, 0.20 and 0.30, the result is 0.0360. Leaving out the correlation gives 0.06, which would be the covariance only if the assets were perfectly correlated.

  1. A0.0360Correct
  2. B0.0600
  3. C0.0180
  4. D0.3600

Explanation

Cov = rho × sigma_X × sigma_Y = 0.60 × 0.20 × 0.30 = 0.0360. Omitting the correlation gives 0.06. Using 0.60 × 0.30 gives 0.18, which is not a covariance of the two volatilities.

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