Jan 07

Covariance and Correlation - 12 min tutorial

by David Harper, CFA, FRM, CIPM

Here is a 12 minute tutorial on the correlation coefficient. The covariance and the correlation coefficient are related by volatility. If an analogy helps, standard deviation is to variance as correlation is to covariance (volatility:variance::correlation:covariance). That's because both variance and covariance are not intuitive; so we translate them into, respectively, standard deviation and correlation:

Here is the key formula, expressed in two ways. First, the covariance as a function of correlation (rho) and volatilities. Second, the correlation is the covariance divided by the product of volatilities: