Question

Why do firms use covariance in finance? Could I also please have an example?

Thank you

Answer 1

Covariance is very important in Finance. It actually represents the relationship between 2 securities. It can be positive or negative. It 2 securities move together, then it is positive covariance and if it moves inversely, then it is negative covariance.

When you are constructing a portfolio you should understand the covariance among these constituent securities. Say, you want to raise capital for your company. The increase in debt will increase the risk of equity and also the cost of equity will also increase. However, up to a certain amount of debt is good the company to give maximum return on invested capital. So, you need to understand the covariance of the equity, debt or preferred capital and find the optimal portfolio which will give you lease risk but maximum return.