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I have two time series. One with monthly returns on an asset and one with monthly returns on a benchmark index. I have calculated the covariance using the =COVARIANCE.P() formula in excel. Further I want to look at the Beta and $R^2$ and therefore wonder:

Are there any reasons to annualize the covariance? And if, how to do so?

Beta is the:

"... slope of the regression equation"

so does it make any sense to annualize it?

What about $R^2$?

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3 Answers 3

up vote 1 down vote accepted

If you assume that your monthly returns are independent from each other, then the annualized variance of each series, and the covariance can be annualized. This assumption allows you to use V(x1+X2+...+x12) = V(x1) + V(x2) + ... + V(x12) where xi is the return for the month "i". Actually, for this to happen you only need a weaker assumption: that is that interperiod returns correlation or covariance be zero since V(x1 + .. + x12) = Sum(i=1..12,j=1..12,Cov(xi,xj)).

Then if you add the "identically distributed" assumption which means that x1, ... , x12 are just the repetition of the same experiment and follows the same probabilistic law: you get in particular E(x1) = ... = E(x12) (same expected returns) V(x1) = V(x2) = ... = V(x12) (same variance)

Finally, V(x1 + .. X12) = V(x1) + ... + V(x12) = 12 * V(x1) That is: V(annual returns) = 12 times the variance of monthly returns.

Beta and R² are already "normalized" so no need to "annualize" them. Under the same assumptions, you are trying to explain one series of returns with the other using a linear model. Whatever the relation of monthly returns, you will have the same on annual returns.

Final remark: not that assuming independent expected returns means that your monthly returns have no memory. But sometimes, they do: the returns from month i and returns from month i+1 are correlated (see Markov chains for example).

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Can you Annualize Covariance , Beta and R^2 ? Mathematically yes you can. For example you can multiple monthly returns by 12 for asset and benchmark. But Beta is slope regression equation as you pointed out so it will come back as exact same as non-annualized beta. I cannot come up with any reason why you would like to annualize Covariance or R^2 as well.

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If I want to compare covariance, ex. covariance with a different asset and the same benchmark. Would it then be reasonable to annualize the covariance? –  Fred Dec 14 '12 at 12:10
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Why not use correlation coefficient instead of covariance?

$ \rho_{x,y} = \frac{Cov_{x,y}}{std.dev_x * std.dev_y} $

An issue with covariance is that it has units; correlation coefficient is unitless.

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