Covariance
A measure of whether two variables move together: positive if they rise and fall in step, negative if they offset. Its size carries the units of both, so it cannot be compared across pairs.
Where you will meet it
Covariance appears in 15 learning outcomes on the CFA syllabus. A few of them:
- Work out covariance and correlation and explain what they show
“Covariance measures whether two variables move together: positive if they tend to rise and fall in step, negative if they offset.”
- Work out the expected return on a portfolio of two assets
“Portfolio variance depends on the two variances, the weights, and the covariance between the assets, so portfolio standard deviation is generally less than the weighted average of the individual standard deviations.”
- Explain and contrast the three kinds of factor model: macroeconomic, fundamental, and statistical
“Statistical models extract factors from return covariances, fitting the data well but without clear economic meaning.”
- Explain why a time series needs to be covariance stationary and what it means when a series lacks stationarity
“A series is covariance stationary when its expected value, its variance and its covariance with its own past values are constant and finite over time.”
Practise it
Practise covariance until it is automatic: questions that explain every wrong option.
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