Covariance: Meaning and Properties

Covariance of Returns and its Properties

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Question

Which of the following are true regarding covariance?

I. Covariance of returns on two assets is 0 when the returns are unrelated.

II. Covariance will be negative if, when the return on one asset is below expected value, the other return will also be below its expected value.

III. The covariance of returns of an asset with itself is the asset's return variance.

IV. Covariance is the probability weighted average of the cross product of the deviation of each random variable from its expected value.

Answers

Explanations

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A. B. C. D.

A

I, III, and IV are all true. II is false. To make II true, we would have to restate it as "Covariance will be negative if, when the return on one asset is below expected value, the other return will be above its expected value."

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