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Example 2. Suppose that Cov(X, Y ) = −0.9, V ar(X) = 0.45 and
V ar(Y ) = 1.8. Find V ar(2X + Y ).
• Correlation. Suppose that V ar(X) > 0 and V ar(Y ) > 0. Then the
correlation (or correlation coefficient) between X and Y , denoted by
Corr(X, Y ), is
Cov(X, Y )
p p .
V ar(X) V ar(Y )
2
Proof of −1 ≤ Corr(X, Y ) ≤ 1 assuming V ar(X) > 0 and V ar(Y ) > 0.
Consider the problem of finding constants a and b so that
E(Y − a − bX)2
is minimized. Note that
E(Y − a − bX)2
2
= V ar(Y − a − bX) + (E(Y − a − bX))
2
= V ar(Y − bX) + (E(Y ) − bE(X) − a)
2
= b2 V ar(X) − 2bCov(X, Y ) + V ar(Y ) + (E(Y ) − bE(X) − a)
2 2
Cov(X, Y ) Cov(X, Y )
= V ar(X) b − + V ar(Y ) − V ar(X)
V ar(X) V ar(X)
2
+ (E(Y ) − bE(X) − a) ,
where
2
Cov(X, Y )
V ar(Y ) − V ar(X)
V ar(X)
Cov(X, Y )2
= V ar(Y ) 1 −
V ar(X)V ar(Y )
= V ar(Y ) 1 − (Corr(X, Y ))2 ,
so
E(Y − a − bX)2
2
Cov(X, Y ) 2
= V ar(X) b − + (E(Y ) − bE(X) − a)
V ar(X)
+V ar(Y ) 1 − (Corr(X, Y ))2 .
(1)
2
(1) implies that E(Y − a − bX) is minimized when
Cov(X, Y )
b= and a = E(Y ) − bE(X), (2)
V ar(X)
and the minimum of E(Y − a − bX)2 is
V ar(Y ) 1 − (Corr(X, Y ))2 ,