Financial Risk Manager Part 1
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A fund manager is constructing a portfolio consisting of two stocks. Which of the following equations can the manager use to calculate the correlation coefficient if the covariance is 0.0168, the standard deviation of stock A is 0.125 and the standard deviation of stock B is 0.2?
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NNikitesh
A
0.0168/(0.125*0.2)²
B
0.0168/(0.125*0.2)
C
0.0168/(0.125*0.2)¹/²
D
0.0168/(0.125²*0.2²)
Explanation:
The correlation coefficient (ρ) is calculated using the formula: ρ = Covariance(A,B) / (σ_A × σ_B), where σ_A is the standard deviation of stock A and σ_B is the standard deviation of stock B.
Given:
- Covariance = 0.0168
- Standard deviation of stock A (σ_A) = 0.125
- Standard deviation of stock B (σ_B) = 0.2
Therefore: ρ = 0.0168 / (0.125 × 0.2)
Option B correctly represents this formula. Option A squares the denominator, Option C takes the square root of the denominator, and Option D squares each standard deviation separately, all of which are incorrect formulations of the correlation coefficient formula.
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