Question

Consider two projects with returns in various states of nature that have the following relationship; knowing how one project performs gives no information about how the other project performs. In this case, what can we expect the covariance between the two projects to be?

		Equal to (approximately) 0
		Between -1 and 0, but otherwise undetermined
		Equal to (approximately) -1
		Equal to (approximately) 1
		Between 0 and 1, but otherwise undetermined

Answer 1

The correct option is A

The covariance measures the relationship between two variables, which shows in which direction these variables move given the covariance, A positive covariance of +1 Shows the both varaiable will tend to move in similar direction, while Negative covariance shows -1 shows they will tend to move in opposite direction.

A Zero Covariance shows the projects are independent and it is difficult to predict the information how will the other project will perform.

It is calculated by,

Covariance = Standard Deviation of Portfolio * Correlation