Covariance and Correlation

Covariance (Cov)
Cov(1,2) = Σ {[Ri,1 – mean(R1)][ Ri,2 – mean(R2)]}/(n-1)

Cov(1,2) = Σ Pi[Ri,1 – mean(R1)][ Ri,2 – mean(R2)]


Correlation (Cor)
To standardize covaraince, use correlation:

Cor (1,2) = Cov(1,2) / (σ 1 x σ 2)

The correlation coefficient is the relative measure of the relationship between two assets. It is between +1 and -1, with a +1 indicating that the two assets move completely together and a -1 indicating that the two assets move in opposite directions from each other.

Notes:
The correlation between investment grade indexes is greater than the correlation between high yield indexes ; Low correlation between monthly country equity index result in gain from global diversification.