Question

Briefly explain the role of correlations, variance and covariance in portfolio theory.

Answer 1

Role of Coorelation:

This shows how your investments are co related to each other. How they are affecting your return in portfolio.

Coorelation Coefficient ranges between -1 to 1.

If it is near -1 that means your investments are negative with each other and if it is near 1 then it shows they are positive with each other and if it is 0 then they are irrelavant with each other.

Variance :

Variance shows how far they are from their average value. This is calculated using statd deviation of each security and coorelation coeficient of the portfolio. This shows the difference of return over a period of time.

Covariance:

This shows the relation between two assets in the portfolio. Means how two assets are related with each other whether positively or negatively.

This three measures are very important to form a better portfolio. With the help of this measures one can maximize his return of portfolio.