The new volatility calculation for a portfolio combines variances and which other factor?

The correct choice is the covariance, as it plays a crucial role in the calculation of a portfolio's overall volatility. In portfolio theory, volatility is not solely determined by the variances of the individual assets contained within the portfolio; rather, it also considers how these assets interact with each other through their covariances.

When calculating a portfolio's variance (which is the square of volatility), you sum the variances of each asset weighted by their respective portfolio weights and then add twice the sum of the covariances between pairs of assets, also weighted by their weights in the portfolio. This relationship accounts for how the returns of the different assets move in relation to each other, which can lead to diversification benefits or increased risk.

Understanding the impact of covariance is vital for portfolio management, as it allows investors to assess how the combination of different assets can affect overall portfolio risk. By appropriately utilizing both variances and covariances in calculations, investors can make more informed decisions regarding their asset allocation and risk management strategies.