Topic 5 FINC 2011 Tutorial Solutions

# Topic 5 FINC 2011 Tutorial Solutions - FINC 2011 Corporate...

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FINC 2011 Corporate Finance I Tutorial Questions and Solutions Topic 5 – Risk and Return DQ 12 Explain both the covariance and the correlation between two securities. What is the  difference between the two? When is one of the measures preferable to the other? A N S W E R Covariance measures the raw degree of association between two variables. Negative covariance implies than an increase (decrease) in one variable is associated with a decrease (increase) in the other and positive covariance implies than an increase (decrease) in one variable is associated with an increase (decrease) in the other. In the case of stock returns, this is very useful in deciding which stocks we might consider combining into portfolios. Covariance is an absolute measure and it is difficult to infer much about the relationship between the variables (other than the direction). The correlation coefficient is a standardised variation of covariance, i.e. it is the covariance divided by the product of the standard deviations. The resulting number will always lie between +1 and –1, which provides a clear indicator of the relationship between two variables. If two stocks have a correlation coefficient of +1 then their stock returns vary uniformly. If the correlation co- efficient is -1 then stock returns completely offset one another. A more likely scenario is that stocks will be less than perfectly correlated, for example a correlation coefficient of 0.25, which implies that the stock returns will move in the same direction but not to the same extent. Most stocks have less than perfect positive correlation due to the influence of the overall market economy. PQ 4

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## This note was uploaded on 08/22/2011 for the course FINC 2011 taught by Professor Craigmellare during the Three '10 term at University of Sydney.

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Topic 5 FINC 2011 Tutorial Solutions - FINC 2011 Corporate...

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