Principles of Finance · free preview
Correlation Analysis
Correlation measures the strength and direction of the linear relationship between two variables, ranging from minus one to one, and in finance it describes how assets move together, the raw material of diversification.
1. Measuring togetherness
Measuring togetherness
2. Reading correlation values
Reading correlation values
3. Correlation is not causation
Correlation is not causation
4. The road to regression
The road to regression
5. The coefficient's range
What range of values can the correlation coefficient take?
6. Reading 0.8
Two stocks show a correlation of 0.8. What does that imply for diversification between them?
7. The crisis warning
Why do risk managers say correlations are least reliable exactly when most needed?
8. Ice cream and drowning
The classic example notes that ice cream sales correlate with drowning deaths. What is the statistical lesson?
9. Correlation squared
A stock correlates with the market at 0.6. Approximately what share of the stock's variation does the market explain?
10. Negative correlation's gift
Why does a negative correlation between two assets especially please a portfolio builder?
11. The coefficient's letter
What lowercase letter conventionally denotes the correlation coefficient? Write the letter.
12. The explained share's name
What three-word term names the square of the correlation, the share of variation one variable explains in another? Answer in lowercase.
13. The lurking variable's role
What two-word term names the hidden third variable that can make two others correlate without causation? Answer in lowercase.
14. The perfect hedge correlation
To what value must two assets' correlation fall for their combined risk to approach elimination, positive one or negative one? Answer with a signed phrase.
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