Correlation and Covariance Relationships - Essay Example

? Portfolio Analysis 2. Correlation and Covariance a. Correlation according to Cohen (2003) can be defined as the ofthe degree in which two variables are related to each other. For example how is coffee business growth related to the weather patterns? Correlation can either be positive or negative meaning a single variable can affect the other positively or negatively. Covariance on the other hand can be defined as the manner two variables change at the same time. Covariance can be described as how two risky assets go hand-in-hand or in relation to one another (see C. Patrick Doncaster, 2007). If the covariance is positive this implies that the assets returns are simultaneous and if negative, this will imply the returns on the assets are inverse. Correlation and covariance both describe the relationships of two variables and in the way they move whether positively that is together or negatively that is inversely. Looking at the above definitions of covariance and correlation we can clearly see the relationship between the two in the context that correlation will determine the extent to which two variables are connected to each other while covariance will look at the same two variables and asses how they move together. Portfolio diversity is best achieved if the covariance is not in the same direction meaning the assets in the portfolio do not have perfect correlation (see Alexander, 2009). If the two asset variables do not have a direct relationship in terms of their asset returns this will mean that they do not move in the same direction and thus if one is affected by market forces it will not necessarily mean the other will not give good returns and this will cover the deficits of the other asset. . b. Why assets with low or negative correlation reduce portfolio risk A proper portfolio is one that is well diversified in terms of security and asset mix. The issue of risk is minimal in a good portfolio and this can only be achieved by ensuring that the risk factor in all assets is not the same. This will mean that the assets will have to be in different sectors or companies to avoid affecting each other in terms of return there is an asset in the portfolio that is giving good returns so that an investor is not totally exposed. Correlation as earlier defined is the relationship of various assets in a portfolio and how they impact on each other in terms of returns. In case assets have a low correlation according to Lhabitant (2004), this will mean that the assets have a minimal interaction in the market in terms of returns. If one of the assets is affected negatively this will not necessarily mean that the other assets will suffer the same adverse effects to the same degree but in a lesser degree. Negative correlation will mean that the assets have no relationship in terms of performance and this will mean that the performance of individual assets will be independent of the other assets in the same portfolio. A low or negative correlation will minimize the portfolio risk to very low levels because the assets will have no direct relation in terms of negative correlation or minimal relationship in terms of low correlation. This will mean all the assets will act as independent factors in the portfolio despite having a common investor. This will ensure that when one of the assets is not doing well in terms of return all the others will not be affected since they lack a relationship. A good portfolio is aimed at having the lowest risk and this can be best assessed by ensuring the portfolio mix is of assets with low or negative correlation. c. Diversification and why is it important to portfolio risk Diversification in terms of portfolio means minimizing the risk factor by investing in various assets (see Hagin, 2004). This will mean that an investor should not invest all his money in one asset but rather subdivide his money to be invested in various assets so that the risk is well distributed. Suppose an investor invests all his money in one asset this will mean that the risk factor is very high and if the asset underperforms in the market it will mean he will incur losses by probably losing all his money. The same client if he sold some off the investment in the asset and bought different types of assets will mean he has distributed his risk and this is the meaning of diversification. Thus diversification is important in portfolio risk since a portfolio has to have minimal risk and this can be achieved by diversification. 3. Capital Asset Pricing Model a) The role of the “Market Portfolio” in the Capital Asset Pricing Model. The Capital Asset Pricing Model as in Frederic (2009) is the theory used to analyze the relationship between risk and return of assets. Return on asset is the return of the asset free from risk plus the risk premium on the risk factor. This purely based on market extra return over the free risk rate adjusted to the asset systematic risk which is not eliminated by diversification. Market portfolio is a portfolio that includes all the market assets. This means that many risk factors are incorporated in the portfolio and thus a proper risk minimization method has to be deployed. Diversification as good as it is in risk minimization cannot eliminate all the risks in the market portfolio and that’s where the Capital asset Pricing Model comes in. the CAPM has to be incorporated in the market portfolio so that the risk exposure on return of investments is minimized or eliminated completely. The market portfolio uses the market value of investments which is usually the price the asset can be priced currently in the market. The market portfolio uses these market values in the portfolio mix and CAPM’s role is help eliminate the risks held by each asset. b) Capital Asset Pricing Model Beta and how to estimate it for a particular share Capital Asset Pricing Model Beta as in Shannon (2010) is the measure used to check the behavior of a security in relation to the asset cluster or group. The Beta helps the potential investor know the expected return on a particular share. It can be used to predict the performance of an asset like the shares from different firms and then it is calculated to determine which share will give most returns. Beta is the sensitivity in relation to expected excess on asset returns to the expected excess market returns. This means it is a ratio that determines the anticipated return on a share so that a potential investor makes a good choice in which particular share to invest in. c) Model Inefficiency The CAPM model may be considered inefficient because of numerous reasons associated with its assumptions. The CAPM assumes that asset returns are distributed in a normal manner but this is not the case because returns in equity as well as other markets are not distributed normally. This results in large swings in the market more often than it is anticipated with normal distribution. The model holds that risk can be measured through the use of variance of returns, which could be explained by normal distribution of returns. However, for distribution of general return, there exist other measures that can expose more adequately the active as well as the shareholders preferences. In financial investments, risk does not replace variance but it is the likelihood of losing it, which is asymmetric. Similarly, the model assumes that all potential as well as active shareholders can access same data and reach an agreement concerning the risk and anticipated return of all assets (see Frederic P Miller, 2009). The probability belief concerning the shareholders is biased and hence inefficient since the market can be misinformed as a result. Further, the model is inefficient because it does not seem to explain the stock returns variations as it ought to. The model fails to give room to active and prospective shareholders who may agree to take higher risk for lower returns. The model is reluctant by assuming the inexistence of transactions or taxes expenses, which could result into inefficiency. The model due to the composition of its market portfolio can’t be seen and thus inefficient. Last, the model differs from other portfolios that are possessed by individual shareholders. Thus, with all the problems, the model is inefficient and cannot be relied upon all the time but an investor must consult other related portfolios as described in Frederic-P-Miller (2009). References Alexander, C. (2009). Market Risk Analysis:Value-at-Risk Models, New Jersey, Wiley Publishers. C. Patrick Doncaster, A. J. (2007). Analysis of variance and covariance:How to choose and construct models of the life sciences, London, Cambridge University Press. Cohen, J. (2003). Applied multiple regression/Correlation analysis for the Behaviourial Sciences, London, Routledge. Frederic P Miller, A. F. (2009). Capital Asset pricing Model, Saarbrucken, VDM publishing house. Hagin, R. (2004). Investment Management:portfolio diversification, risk and timing-fact and Fiction, New Jersey, Wiley Publishers. Lhabitant, F.-S. (2004). Hedge Funds:Quantitative Insights, New Jersey, Wiley Publishers. Read More