Covariance

Covariance

Covariance measures whether two variables tend to move together.

Formula:

$\text{Cov}(X,Y)=\frac{1}{n}{\sum }_{i=1}^n(x_i-\bar{x})(y_i-\bar{y})$

Interpretation:

• positive covariance: the two series tend to move in the same direction
• negative covariance: they tend to move in opposite directions
• near zero: little linear co-movement

In finance, covariance matters because portfolio risk depends not just on each asset’s volatility, but also on how returns interact.

This matters mainly when reading Standard Deviation of Pool and Risk and Return.