NISM Certifications · NISM-Series-XV: Research Analyst · Fundamentals of Risk and Return
Two stocks A and B have standard deviations of 20% and 10% respectively, and a correlation coefficient of 0.5 between their returns. What is the covariance between the returns of A and B?
The covariance is 0.010. It equals the correlation coefficient multiplied by the two standard deviations: 0.5 times 0.20 times 0.10. Leaving out the correlation would give 0.020, which is the product of the standard deviations alone and is incorrect.
- A0.010Correct
- B0.020
- C0.100
- D0.050
Explanation
Covariance = correlation × SD(A) × SD(B) = 0.5 × 0.20 × 0.10 = 0.010. Working back: 0.010 / (0.20×0.10) = 0.5, matching the data. 0.020 omits the correlation factor.
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