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LOS 9.m: Calculate and interpret co variances
given a joint probability function, p190. Session Unit 2:
9. Probability Concepts
Example: Covariance matrix: Assume you have a portfolio that consists of Stock S and a put option O
on Stock S. The corresponding weights of these portfolio assets are wS = 0.90 and wO = 0.10. Using the
covariance matrix provided in the following table, calculate the variance of the return for the portfolio.
Answer:
Recall that the covariance of an asset with itself is its
variance.
Thus, the terms along the diagonal in the
i
covariance matrix are return variances.
Var(RP) =
(0.90)2(0.0011) + (0.10)2(0.016) + 2(0.90)(0.10)(–0.0036) =
0.000403
