Blog Home / Financial Terms / What is Covariance?

What is Covariance?

Covariance is a measure of dispersion that captures how the variables move together.

What is Covariance?

Covariance is a measure of dispersion that captures how the variables move together. Note that it is a generalisation of the variance, and the covariance of a variable with itself is just the variance. The covariance is technically a 2-by-2 matrix of values where the values along one diagonal are the variances of X1 and X2, and the terms in the other diagonal are the covariance between X1 and X2.

Example of Covariance:

For Population:
$ Cov(x,y)= \frac{\sum (x_{1}-x)*(y-y)}{N} $

For Sample:
$ Covx,y= \frac{\sum (x_{1}-x)*(y-y)}{N-1} $

What is the importance of covariance?

Covariance assists risk professionals in identifying the relationship between two variables. However, one of the disadvantages of covariance is that it doesn’t give the actual strength of the relationship between two variables, which is covered by correlation.

Owais Siddiqui
1 min read
Shares

Leave a comment

Your email address will not be published. Required fields are marked *