CMA Final · Strategic Financial Management · Portfolio Theory and Practice
Two assets A and B have standard deviations of 20% and 30% respectively. Their correlation coefficient is 0.5. What is the covariance between the returns of A and B?
The covariance is 0.0300. Covariance equals the correlation coefficient multiplied by the two standard deviations, so 0.5 x 0.20 x 0.30 gives 0.03. Ignoring the correlation would wrongly give 0.06.
- A0.0150
- B0.0300Correct
- C0.0600
- D0.0100
Explanation
Covariance = correlation x SD_A x SD_B = 0.5 x 0.20 x 0.30 = 0.03. The option 0.0600 results from omitting the correlation factor (0.20 x 0.30). The option 0.0150 halves the result again by mistake.
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