Covariance - Financial definition
Concise definition of the term covariance
Covariance measures the degree to which two variables move together. A positive covariance indicates that the variables tend to move in the same direction, while a negative covariance indicates that they move in opposite directions.
Comprehensive definition of the term covariance
Covariance is a statistical measure that quantifies the degree to which the movements of two random variables are associated. It provides insights into the direction of their relationship: a positive covariance indicates that the variables tend to move in the same direction, while a negative covariance suggests they move in opposite directions. In finance, covariance is widely used in portfolio management to assess the diversification benefits of combining different assets. For example, a portfolio manager might analyze the covariance between the returns of stocks within a portfolio to determine the level of risk reduction achieved through diversification. Additionally, covariance plays a crucial role in the calculation of the efficient frontier and the optimization of portfolio weights to achieve an optimal balance between risk and return.