FRM Part II · FRM Exam Part II · Correlation Basics: Definitions, Applications, and Terminology
Two assets have return standard deviations of 10% and 20%, and a correlation of 0.30. What is the covariance of their returns?
Covariance equals correlation times the product of the standard deviations: 0.30 x 0.10 x 0.20 = 0.0060. Options such as 0.0200 ignore the correlation, while 0.0600 and 0.6000 reflect scaling errors from using percentage figures.
- A0.0060Correct
- B0.0200
- C0.0600
- D0.6000
Explanation
Cov = rho x sigma1 x sigma2 = 0.30 x 0.10 x 0.20 = 0.0060. Using percentages (0.30 x 10 x 20 = 60) gives a unit error; omitting correlation gives 0.0200.
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