Significance of Correlation

 

Meaning of Correlation

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.

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.

Key Takeaways

• 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.