We are given Stock S and put option O on stock S. The corresponding weights for these assets are W s=90% and W o=10%. Using the following covariance matrix, calculate the variance of the return for the portfolio.
Returns R s R o
R s 0.0011 -0.0036
R o -0.0036 0.0011
Variance( R p) = weight(x)^2 * variance(return X) + weight(y)^2 * variance(return Y) + 2*weight(x)*weight(y)*covariance
So, given the above I get:
(90%)^2 * (0.0011) + (10%)^2 * (0.016) + 2*(90%)*(10%) and for covariance I get (0.0011)^.5 * (0.016)^.5 * (-0.0036) = -0.00002
However, the book says I input -0.0036 for covariance yet in a similar problem (one with three assets, not two) we computed variance by SD(asset 1) * SD(asset 2) * the returns correlation between the two.
Why do I not do that here?
Thanks.
I computed covariance by getting the SD of (Rs) and (Ro) then multiplying by the correlation of (Rs and Ro) of -0.0036 .03317 * .12649 * -0.0036 = -0.00002.