Meaning of Correlation, Importance

09/02/2020 0 By indiafreenotes

Correlation, in the finance and investment industries, is a statistic that measures the degree to which two securities move in relation to each other. Correlations are used in advanced portfolio management, computed as the correlation coefficient, which has a value that must fall between -1.0 and +1.0

A perfect positive correlation means that the correlation coefficient is exactly 1. This implies that as one security moves, either up or down, the other security moves in lockstep, in the same direction. A perfect negative correlation means that two assets move in opposite directions, while a zero correlation implies no relationship at all.

For example, large-cap mutual funds generally have a high positive correlation to the Standard and Poor’s (S&P) 500 Index – very close to 1. Small-cap stocks have a positive correlation to that same index, but it is not as high – generally around 0.8.

However, put option prices and their underlying stock prices will tend to have a negative correlation. As the stock price increases, the put option prices go down. This is a direct and high-magnitude negative correlation.

  • Correlation is a statistic that measures the degree to which two variables move in relation to each other.
  • In finance, the correlation can measure the movement of a stock with that of a benchmark index, such as the Beta.
  • Correlation measures association, but does not tell you if x causes y or vice versa, or if the association is caused by some third (perhaps unseen) factor.

Importance of correlation Analysis

Correlation is very important in the field of Psychology and Education as a measure of relationship between test scores and other measures of performance. With the help of correlation, it is possible to have a correct idea of the working capacity of a person. With the help of it, it is also possible to have a knowledge of the various qualities of an individual.

After finding the correlation between the two qualities or different qualities of an individual, it is also possible to provide his vocational guidance. In order to provide educational guidance to a student in selection of his subjects of study, correlation is also helpful and necessary.

Correlation Statistics and Investing

The correlation between two variables is particularly helpful when investing in the financial markets. For example, a correlation can be helpful in determining how well a mutual fund performs relative to its benchmark index, or another fund or asset class. By adding a low or negatively correlated mutual fund to an existing portfolio, the investor gains diversification benefits.

In other words, investors can use negatively-correlated assets or securities to hedge their portfolio and reduce market risk due to volatility or wild price fluctuations. Many investors hedge the price risk of a portfolio, which effectively reduces any capital gains or losses because they want the dividend income or yield from the stock or security.

Correlation statistics also allows investors to determine when the correlation between two variables changes. For example, bank stocks typically have a highly-positive correlation to interest rates since loan rates are often calculated based on market interest rates. If the stock price of a bank is falling while interest rates are rising, investors can glean that something’s askew. If the stock prices of similar banks in the sector are also rising, investors can conclude that the declining bank stock is not due to interest rates. Instead, the poorly-performing bank is likely dealing with an internal, fundamental issue.