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1. Welcome back.

2. I hope I have given you a little inkling of

3. why we are thinking about relationships.

4. And the reason is, basically risk aversion,

5. which leads us to whole portfolios.

6. So I'm going to stick with two returns in a portfolio, or

7. two returns because if you make it more complex right away it'll become
tough.

8. So think of two securities, two things.

9. One distribution is here, another distribution is here.

10. And let's for, just for the fun, call this Amazon,

11. and let's, for fun, call this Microsoft.

12. Two companies most people have dealt with, know about, and so on.

13. So you have Amazon, you have Microsoft.

14. The question then becomes, can you calculate the return on Amazon?

15. Yes, I can calculate the return, I'll call it RA.

16. Z just for the heck of it, RAZ bar, and sigma hat AZ.

17. Here I can calculate R Microsoft bar and sigma hat Microsoft.

18. For being able to calculate it, which I promise you we will do with real data.

19. What do you need?

20. You need data to be able to do it.


21. Either continuous data, or discrete data and usually we'll have continuous
data but

22. I'll do both.

23. Because you need to understand concepts, data applications very clearly.

24. Okay, so you've done both, but what do I want to also measure?

25. Because they're both sitting in my portfolio, of risk averse person.

26. Assuming you can afford to invest, I guarantee you that if you're a risk
averse

27. person, they are somehow showing up in a broad portfolio.

28. So the measure of relationship is called covariance.

29. And covariance is interesting, why, because what does it measure?

30. It measures how these two move together.

31. So if RAZ- RAZ bar,

32. what would you call that?

33. It would be at this point, this distance.

34. At this point it would be this distance.

35. This would have a what sign?

36. Negative sign, this would have a positive sign.

37. So this is negative, this is positive.

38. Similarly, there

39. will be RMS- RMS bar.

40. Quick question, what do you need to know to calculate which?


41. You need to know all RSZs to calculate this or RMS.

42. So this changes, this is a number,

43. one number based on all the data you have, okay?

44. So suppose you're looking at this item.

45. And then you ask yourself,

46. what is happening to Microsoft when this is negative?

47. How will you measure that?

48. You'll go measure a specific instance of that,

49. multiply the two that shows you how they're related.

50. But how many of them are there?

51. So if you'll take the regular formula, the longer formula, it is sigma i p i.

52. So the probability of event i, RAZ how is related to its mean?

53. And multiply that by RNZ, how it's related to risk.

54. So basically what it's measuring is,

55. over the entire full set of possibilities, i, how are they related?

56. So let me ask you a simple question.

57. Suppose when this is negative, this also tends to be negative.

58. Not by the same amount, necessarily, not exactly the same amount.

59. But, and when this tends to be positive, this also tends to be positive.

60. On average, what will this number be?

61. Greater than 0.


62. But on the other hand,

63. which happens rarely in the stock market between two stocks, we'll see why.

64. If this tends to be positive, this tends to be negative, the sign will be
negative.

65. And in a very strange circumstance,

66. suppose Amazon does whatever it does return, has nothing to do with
Microsoft.

67. So when it's negative, this then should be positive and when it's positive,

68. this then should be negative.

69. The relationship is 0.

70. Very, very unlikely, in the real world, in the stock market.

71. The two returns, you'll see when it will happen, and you'll see why it's
unlikely.

72. So what is covariance measuring?

73. Covariance is measuring the relationship between risk,

74. I mean between two different companies.

75. And we can think of it many pairs of company, okay.

76. There is a problem with the covariance.

77. And what I'm going to do is show you why.

78. I will repeat this whole exercise and show you why there's a problem.

79. So I'm going to now go from covariance to something called correlation.

80. Okay, so remember


81. the covariances were sigma,

82. bi, RAZ- RAZ bar,

83. times RMS- RMS bar.

84. The trouble with covariance is there are two things.

85. One, that it is dependent on the units, so let me distract for

86. a second from Amazon and Microsoft.

87. And actually that's what I love about statistics.

88. Suppose this is rainforest, I mean this is rain.

89. [LAUGH] And this is crops.

90. So suppose this is measured in inches and this is measured in bushels.

91. Bushels is a way of measuring how much output you have in a crop.

92. What will be the unit of measurement?

93. Inches, bushels, two different units, very confusing.

94. In the case of returns because they are measured in percentage terms,

95. it doesn't jump out at you.

96. But it's very important to recognize that covariance is unit measurement
dependent.

97. Point number one, not a good thing because you cannot compare rain and

98. bushels with returns, or with advertising dollars' effect on sales.

99. So units shouldn't matter to something, if you want to compare things.

100. So, covariance is a very, very important concept, but


101. it suffers from unit dependence.

102. The second problem it suffers from, and I'll spend a little bit of time.

103. There's a little bit lengthy because I want to finish relationships

104. all at once rather than keep doing snippets of it.

105. The other problem, so first is unit dependent.

106. The second problem is I can make its magnitude big or

107. small, and it doesn't mean much.

108. What do I mean by that?

109. So, suppose we take the examples of inches and bushels.

110. Instead of measuring inches, suppose I decided to measure in millimeters.

111. There are a lot of millimeters in inches, and, suddenly, the number will blow
up.

112. So, it's also the magnitude

113. doesn't necessarily tell you anything, which is not a good thing, right?

114. So you would imagine 500 is more than 300, it should matter somewhat.

115. No, so the main value of covariance is

116. that you have to calculate it to figure out relationships.

117. The problem is that it's unit dependent and its magnitude may not make
sense.

118. But why do you have to calculate it?

119. It's sign that is most important.

120. Meaning if it is greater than zero, less than zero, or zero, tells
121. you the nature of the relationship, but nothing about the units of the
magnitude.

122. Those are very confusing.

123. So how do you go from here to something?

124. That measures the relationships, retains the beauty of covariance, but

125. adjusts it for the two problems.

126. What do you do?

127. You standardize it.

128. You divide it by standard deviation,

129. easy, and standard deviation of MS.

130. What have you done?

131. You've created something called correlation.

132. What I want to emphasize about correlation is

133. that correlation gets rid of units issue of covariance.

134. First thing, why?

135. Because think of this as what?

136. Inches of rain and this is bushels.

137. This is inches, this is inches, cancels.

138. This is bushels, this is bushels, cancels.

139. It becomes a number.

140. In other words, you can compare numbers.


141. It's unit free, so it's unit free, yeah.

142. Pretty obvious, excellent quality to have.

143. The second very good quality about correlation is you can show

144. that it will be between + and -1.

145. Now that's awesome too.

146. So when you see correlation of 0.8 positive

147. versus 0.6 positive, which one is stronger?

148. 0.8, you can say that.

149. You couldn't say that about covariance.

150. But finally, do not forget that covariance is playing a very, very important
role.

151. You cannot calculate correlation without covariance, why?

152. Because it's determining the sign.

153. So the basic nature of the relationship has been determined by covariance.

154. We'll take a break now, come back with one final concept,

155. which is related to all of this and it's called regression.

156. We'll spend one more segment on it within the context,

157. hopefully a reasonably short one.

158. And then we'll come back to applications and applications with data,

159. revisit our everything.

160. But we will have covered the fundamentals of statistics that you need to
know for
161. finance, at least the introductory finance.

162. And of course, you could apply it to many other things like we talked about,
rain,

163. and bushels, and so on, so forth.

164. See you in a minute for another five minutes or so.

165.

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