Financial Risk Manager Part 1
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Which of the following statements is most accurate regarding a negative covariance between two assets?
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NNikitesh
A
The returns of two assets move together in the negative direction.
B
The returns of two assets move in opposite directions.
C
The returns of two assets are move in the positive direction.
D
None of the above.
Explanation:
Explanation
Negative covariance indicates that two variables tend to move in opposite directions. When one variable increases, the other tends to decrease, and vice versa.
Key points:
- Covariance measures the directional relationship between two random variables.
- Positive covariance indicates that the variables move together in the same direction.
- Negative covariance indicates that the variables move in opposite directions.
- Zero covariance indicates no linear relationship between the variables.
Why other options are incorrect:
- Option A: "The returns of two assets move together in the negative direction" - This is incorrect because negative covariance doesn't mean both returns are negative; it means they move in opposite directions.
- Option C: "The returns of two assets are move in the positive direction" - This describes positive covariance, not negative covariance.
- Option D: "None of the above" - This is incorrect because option B is the correct answer.
Example: If Asset A's returns increase when Asset B's returns decrease (and vice versa), they have negative covariance.
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