Quantitative Methods #5: Relations Between Events

In the past few posts, I took a look at return/risks for individual assets. Those are critical to understand but as you know we live in a much more complex world than that. Events are rarely random. In most cases, there are relations between the returns of two assets and it is important to consider these relations. When a portfolio manager considers buying or selling an asset, it is important to consider the correlation between that asset and the portfolio. You should know these concepts:

-When discussing an “event,” the probabilities of an event happening is between 0 and 1.  Knowing that one event, A, occurred, the probability of the 2nd event, B, is changed.

P (A | B) is the probability of A knowing that B occurred

P (AB) = P (A) + P (B)

P (A or B) = P (A) + P (B) – P (AB)

If the two events have absolutely no relationship, the probability of B occurring would be the same no matter if A occurred:

P (B) = P (B | A)

Covariance is a measure that will determine how far one variable will be from its mean when the other one is. The stronger the covariance, the stronger the relationship

Correlation is a measure to understand the relationship between the two variables. It ranges between -1 and 1 where -1 is a complete opposite relationship, 0  is no relationship and 1 would be two assets correlated at 100%


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