Measures of Correlation

Pete Smith, PRM, FSA, MAAA Correlation has many uses and definitions. As Carol Alexander, 2001 observes, orrelation may only be meanin!fully om"uted for stationary "ro esses. Covarian e stationarity for a time series, yt, is defined as# Constant, finite mean Constant, finite varian e Covarian e$yt, yt%s& de"ends only on the la! s

For finan ial data, this im"lies that orrelation is only meanin!ful for variates su h as rates of return or normally transformed variates, ', su h that# ' ( $x % &) *here x is non%stationary and is the mean of x and the standard deviation. For non% stationary variates li+e "ri es, orrelation is not usually meanin!ful. A more oherent measure of relatedness is ointe!ration. Cointe!ration uses a t,o%ste" "ro ess# -on!%term e.uilibrium relationshi"s are established A dynami orrelation of returns is estimated

Cointe!ration ,ill not be dis ussed in these /RM sessions, ho,ever, it is very im"ortant in develo"in! dynami hed!es that see+ to +ee" stationary tra +in! error ,ithin "reset bounds. 0ed!in! usin! orrelation measures ty"i ally is not able to a hieve su h ontrol. 0o,ever, instantaneous and terminal measures of orrelation are used in various a""li ations su h as develo"in! sto hasti interest rate !enerators.

Definitions of Correlation
Pearsons correlation formula -inear relationshi"s bet,een variables an be .uantified usin! the Pearson Produ t% Moment Correlation Coeffi ient, or

1he value of this statisti is al,ays bet,een %1 and 1, and if ,ill e.ual 'ero.

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$sour e# htt"#))mai!ret."sy.ohio% state.edu)2trish)1ea hin!)3ntro4Stats)-e ture45otes) ha"ter6)node6.html& Spearman's Correlation Method A non"arametri $distribution%free& ran+ statisti "ro"osed by S"earman in 1708 as a measure of the stren!th of the asso iations bet,een t,o variables $-ehmann and 9:Abrera 177;&. 1he S"earman ran+ orrelation oeffi ient an be used to !ive an R% estimate, and is a measure of monotone asso iation that is used ,hen the distribution of the data ma+e Pearson:s orrelation oeffi ient undesirable or misleadin!. 1he S"earman ran+ orrelation oeffi ient is defined by $1&

,here d is the differen e in statisti al ran+ of orres"ondin! variables, and is an a""roximation to the exa t orrelation oeffi ient $2&

om"uted from the ori!inal data. <e ause it uses ran+s, the S"earman ran+ orrelation oeffi ient is mu h easier to om"ute. 1he varian e, +urtosis, and hi!her%order moments are $=& $8& $6&

Student ,as the first to obtain the varian e.

wine a b c d e f ' h $=.

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$sour e# htt"#))math,orld.,olfram. om)S"earmanRan+CorrelationCoeffi ient.html& The Simple Formula for rs, for Rankings without Ties Here is the same table you saw above, except now we also take the difference between each pair of ranks (D=XY), and then the s uare of each difference! "ll that is re uired for the calculation of the #pearman coefficient are the values of $ and% D&, accordin' to the formula rs = ( ) D& $($&()

$sour e# htt"#))fa ulty.vassar.edu)lo,ry) h=b.html& 1here is no !enerally a e"ted method for om"utin! the standard error for small sam"les.

Kendall's Tau Coefficient S"earman>s r treats ran+s as s ores and om"utes the orrelation bet,een t,o sets of ran+s. ?endall>s tau is based on the number of inversions in ran+in!s. Althou!h there is eviden e that ?endall:s 1au holds u" better than Pearson:s r to extreme nonnormality in the data, that seems to be true only at .uite extreme levels.

-et inv #( number of inversions, i.e. reversals of "air%,ise ran+ orders bet,een n "airs. /.ual ran+in!s need an ad@ustment. ( 1 A 2B inv)$number of "airs of ob@e ts& ( 1 % 2 B inv) $nB$n%1&)2& ( 1 A 8B inv)$nB$n%1&& $sour e# htt"#)),,,."sy h.yor+u. a)dand)ts")!eneral) orrstats."df& BBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBB 1he "re edin! orrelation definitions ,ei!ht all observations e.ually. 0en e, lusterin! of data asso iated ,ith "eriods of hi!h and lo, volatility is not refle ted. 0i!h volatility "eriods often dis"lay hi!her levels orrelation ris+. For exam"le, ,hen the Russian Rouble be ame distressed and hi!hly volatile in 177;, the third ,orld debt mar+et ex"erien ed onta!ion. 1he S"earman and ?endall 1au measures are more a""ro"riate for non%normal distributions. 1he above definitions of orrelation are absolute and ,ill only a identally re"li ate im"lied mar+et orrelations. <ayesian or onditional definitions of orrelation are more a""ro"riate for time series and sto hasti models as relationshi"s su h as volatility smiles may be a"tured. BBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBB

Instantaneous Correlation i@$u& #( instantaneous orrelation bet,een variables ,ith indi es i,@ a moment u. $see Rebonato, Modern Pricing of Interest-Rate Derivatives, 2002& 3nstantaneous orrelation in a hed!in! model may be based on fore asts of future orrelation. An em"iri al fun tion relatin! the value of a "osition to the asso iated orrelation may be derived. 1he em"iri al fun tion is then used to vary instantaneous orrelation as the underlyin! value of the "osition han!es. 3nstantaneous orrelations my then be used to om"ute the asso iated terminal orrelation. Terminal Correlation term4i@$1& ( C013$u&@$u&i@$u&duD ) $viv@&

,here# vi ( 01i$u&2du 1erminal orrelation is usually the more !ermane measure of orrelation for "ri in! and hed!in!. $see Rebonato, Modern Pricing of Interest-Rate Derivatives, 2002& Implied Correlation 1he im"lied volatility on the ross rate on a forei!n ex han!e "ro ess may be ex"ressed as# 2x%y ( 2x E 2y %2xy ,hi h may be solved o"tions are available on the f)x rates and ross, i.e.# ( $2x E 2y % 2x%y&)$2xy& 3n the above exam"le, is the im"lied orrelation. $see Alexander, Market Models, 2001&

Confidence Intervals for Correlation Point Estimates: Fisher ! transformation

-et be a "oint estimate of the orrelation r, define the transformation '# ' ( F lnC$1Er&)$1%r&D *hen the sam"le is lar!e $26 or more is a useful rule of thumb&, the distribution ' is a""roximately normal ,ith an a""roximate mean and varian e# /$'& ( F lnC$1E&)$1%&D and $'& ( 1)$$n%=&& 1he standardi'ed statisti , $' A /$'&&)$'&&, is a""roximately a standard normal variable. 1herefore, a""roximate 1 % onfiden e limits for ' are# /$'& $1 % )2&$'&. 1he 1 % limits for are then obtained by transformin! the limits on ' by means of# ( $ex"$2'& A 1&)$ex"$2'& E 1&

"elationship #et$een Correlation and %olatilit&

3n Volatility and Correlation in Option Pricing,1 orrelated variables, Ri ardo Rebonato states, , in the ontext of t,o im"erfe tly

GHnder these assum"tions ,e an no, run t,o simulations, one ,ith a onstant Iidenti al volatility for both variables and ,ith im"erfe t orrelation, and the other ,ith different instantaneous im"erfe t orrelation, and the other ,ith instantaneous volatilities Ibut "erfe t orrelation. Jne an then evaluate orrelation, al ulated alon! the "ath, bet,een the han!es in the lo! of the t,o variables in the t,o ases. IAs is a""arent from the t,o fi!ures, the same sam"le orrelation an be obtained des"ite the fa t that the t,o de% orrelation% !eneratin! me hanisms are very different.

3n Market Models, 2001, Carol Alexander observes, GHnli+e "ri es, volatility and orrelation are not dire tly observable in the mar+et. 1hey an only be estimated in the ontext of a model. 3t is im"ortant to understand that im"lied and statisti al volatility models "rovide estimates or fore asts of the same thin!Kthat is, the volatility "arameter in some assumed underlyin! "ri e "ro ess. 1he follo,in! em"iri ally derived !ra"hs sho, instantaneous orrelations as a fun tion of o"tion value. 1hese relationshi"s allo, fore ast and simulation "ro esses to vary orrelation onditional on the level of the o"tion "ri e.

Correlation Methods
'("C) Models: 'enerali!ed (utore*ressive Conditional )eteroscedastic $Referen e for LARC0 Models# Carol Alexander, Market Models, 2001& )eteroscedastic models have varyin! volatility. LARC0 models are Conditional time series models ,here the urrent variable volatility de"ends on "rior values. (uto"e*ressive models have the mean reversion "ro"erty. 1he 'enerali!ed form of the model results in instan es that onstitute a family of models ,ith varyin! "arameters. LARC0 models are im"ortant in finan e be ause they enable modelin! of volatility lusterin!. Molatility lusterin! o urs be ause "eriods of hi!h volatility in tradin! finan ial assets are inters"ersed ,ith "eriods of lo, volatility. LARC0 models enable lusterin! to be a"tured ,ithout im"lementin! full haos models. Full haos finan e models often develo" in om"lete mar+ets, i.e. re"li atin! strate!ies ,ill not exist. ("C)+p, 1he ARC0$"& "ro ess a"tures the onditional heteros eda ti ity as a ,ei!hted avera!e of "ast s.uared unex"e ted returns# 2t ( 0 E 12t%1 E I E "2t%" 0 N 0, 1, I, " 0 t 3t 5$0, 2t& ARC0 models are rarely used in finan e as sim"le LARC0 models "erform so mu h better. '("C)+p-.,: S&mmetric '("C) 2t ( 0 E 12t%1 E I E "2t%" E 1t%1 E I E .2t%. 0 N 0, 1, I , ",1, I, . 0 3t is rarely ne essary to use more than a LARC0$1,1& model for finan ial a""li ations. '("C)+/-/, 2t ( E 2t%1 E 2t%1

 N 0, , 0 1he LARC0$1,1& model is e.uivalent to an infinite ARC0 model ,ith ex"onentially de linin! ,ei!hts. I '("C) E O 1 if the returns "ro ess is to be stationary. *hi h is ne essary for mean revertin! "ro esses. 3f E ( 1, the return "ro ess is a random ,al+, and the LARC0$1,1& "ro ess may be ex"ressed as# 2t ( E $1 % &2t%1 E 2t%1 (, 10 Su h models are alled integrated LARC0 or 3%LARC0 models. 3%LARC0 models are often a""ro"riate in forei!n ex han!e mar+ets. *hen ( 0, the 3%LARC0 model be omes an /*MA $ex"onentially ,ei!hted movin! avera!e& model. ( '("C): (s&mmetric '("C) /.uity mar+ets are ty"i ally more volatile in fallin! mar+ets than risin! mar+ets. A%LARC0 models ,ere desi!ned to fit su h mar+ets. E '("C): E0ponential '("C) 1he first A%LARC0 model ,as the /%LARC0 or /x"onential LARC0 model, of the follo,in! form# ln 2t ( E !$'t%1& E ln2t%1 ,here !$B& is an asymmetri res"onse fun tion defined by# !$'t& ( 't E $ P'tP % $2&& 't is the standard normal unex"e ted return t)t

1 '("C): non linear '("C) rt ( r % .62t E tt 2t ( E 2t%1$t%1 % % &2 E t%1 t ( t E 5%LARC0 models are ty"i ally not ris+%neutral, althou!h lo al ris+%neutrality may exist. Models that are not ris+%neutral are in om"lete and !enerally do not have re"li atin! "ortfolios every,here available. 0en e, hed!in! may not be "ossible. 1y"i ally 5%LARC0 models are more om"lex than the "re edin! LARC0 models in this "resentation. For these reasons 5%LARC0 models are not urrently used as extensively in finan e as other LARC0 models. )i*h Fre.uenc& '("C) Models Model fre.uen y is a fun tion of the time interval asso iated ,ith return observations. So hourly observation is more fre.uent than daily and daily is more fre.uent than ,ee+ly, and so on. Most LARC0 models in "ra ti e assume that unex"e ted "ortion of the a tual return is onditionally normally distributed. 5on%normal models are hara teri'ed by fat tailed distributions for the unex"e ted "ortion of the return. t '("C) models develo" the unex"e ted "ortion of the return a ordin! to a student%t distribution. 5on%normal models may be develo"ed by modifyin! the li+elihood fun tion used to estimate the model "arameters. 0i!h fre.uen y models, es"e ially intra%day models, are mu h more li+ely to be more volatile and fat%tailed than lo,er fre.uen y models.

"elationship of Correlation and %a"

Covarian e MaR han!es linearly as the underlyin! model or fa tor variable instantaneous orrelations han!e. -i+e,ise non%linear MaR ,ill han!e non%linearly as

the instantaneous orrelations han!e. 9ynami hed!in! osts should "ro"erly refle t the MaR ost of a"ital.

#i2lio*raph& and Future "eadin*s

Marious readin!s have been referen ed throu!h the "ro!ress of this "resentation. As the "resentation is intended to "rovide a summary of orrelation on e"ts in "re"aration for the subse.uent sessions, the on e"ts herein are not ori!inal to the "resenter. A !uide to ori!inal ,or+ is "rovided so that attendees may develo" a dee"er understandin! of the sub@e t. Carol (le0ander- Market Models, Wiley, 2001 3f you read one boo+ on these sub@e ts, Ms. Alexander>s Market Models is hi!hly re ommended. 1he boo+ ontains lu id and intuitive summaries of hi!hly om"lex ideas. Market Models is a "leasure to read. "icardo "e2onato- Volatility and Correlation in Option Pricing, 3ile&- /444 Volatility and Correlation dis usses advan ed to"i s beyond Market Models. -i+e all of Rebonato>s boo+s, it is hi!hly lu id and em"iri ally fo used. 5ther "ecommended "eadin*s /n!le, 200! Risk "#$ "resentation Mante!na and Stanley, $n Introd%ction to &conop'ysics ( Correlation and Co)ple*ity in +inance, Cambrid!e, 2000 <ou haud and Potters, ,'eory of +inancial Risks, Cambrid!e , 2000 Interestin* (pplied Models R. Rebonato, Modern Pricing of Interest-Rate Derivatives( ,'e -i.or Model and /eyond, Prin eton Hniversity Press, 2002 Q. Rosenber!, 0on-Para)etric Pricing of Contingent Clai)s, Qournal of 9erivatives, S"rin! 200=