Question

When we calculating the covariance and correlation coefficient between two securities, what is the best period to calculate these things (i.e. 3 months, 12 months, 5 years or 9 years) and why?

Answer 1

It is recommended not to take the data for calculating covariance & correlation not too short as in 3 months or not too large as in 9 years.

If we take a short span, the short term news or incidents like change in CEO, controversy etc can affect the stock price of one of the stock to significantly varies which will not provide an actual relation between 2 stocks. Similarly if the period is too large, there can be chances of merger and acquisition of any of the companies through which the entire company cashflow can get affected and hence the variation of stock price between the 2 companies. Also 9 years data cannot show the future covariance accurately since the time period is too large.

Due to these it is recommended to take 12 years ideally also 5 years can be taken if there is no proper change in business alignment of both the companies.