Covariance indicates the relationship of two variables each time a variable changes. If an increase in one variable results in an increase in the other variable, both variables are said to have a positive covariance. decreases in one variable also cause a decrease in the other. both variables move together in the same direction when they change. decreases in one variable that result in the opposite change in the other variable are called negative covariance. These variables are inversely related and always move in different directions. when a positive number is used to indicate the magnitude of the covariance, the covariance is positive. A negative number represents an inverse relationship.The concept of covariance is commonly used when discussing the relationships between two indicators or economic terms. for example, Market values of publicly traded companies typically have a positive covariance with reported earnings. Similarly, the value of one security can increase when another increases.Covariance calculations are also used in modern portfolio theory (mpt).
If two stocks have stock prices with a positive covariance, they are both likely to move in the same direction when responding to market conditions. Both actions can be tracked over a period of time with the rate of return for each recorded period of time. Determining the covariance of two variables is called analysis of covariance. For example, conducting an analysis of covariance on stocks a and b records rates of return for three days. share a has returns of 1.8%, 2.2% and 0.8% on days one, two and three respectively. Stock b returns 1.25%, 1.9%, and 0.5%. both stocks increased and decreased on the same days, so they have a positive covariance.when plotting on the ax / y axis, the covariance between two variables is visually displayed since both variables reflect similar changes at the same time. Covariance calculations provide information on whether the variables have a positive or negative relationship, but cannot reveal the strength of the connection. the magnitude of the covariance can be biased whenever the data set contains too many significantly different values.A single outlier in the data can drastically change the calculation and exaggerate or underestimate the relationship. Covariance helps economists predict how variables react when changes occur, but they cannot predict as effectively how much each variable changes.
Covariance is frequently used in mpt. When building efficient financial portfolios, financial managers seek investment mixes that provide optimal returns and minimize risks. The risk / return trade-off concept demonstrates that increasing investment risks often requires increased returns. This is the result of investors’ desire to minimize risks and maximize returns. When subprime loans are offered, the lender must protect the investment by charging higher rates. Different asset classes, different companies, and different borrowers’ credit histories all generate different rates.Covariance is used in portfolio management theory to identify efficient investments with the best rates of return and risk levels to create the best possible portfolios. on a regular basis,
