10/19/2020 Correlation - Overview, Formula, and Practical Example

What is a Correlation?

A correlation is a statistical measure of the relationship between two variables. The measure
is best used in variables that demonstrate a linear relationship between each other. The t
of the data can be visually represented in a scatterplot. Using a scatterplot, we can generally
assess the relationship between the variables and determine whether they are correlated or
not.

The correlation coe cient is a value that indicates the strength of the relationship between
variables. The coe cient can take any values from -1 to 1. The interpretations of the values
are:

-1: Perfect negative correlation. The variables tend to move in opposite directions (i.e.,
when one variable increases, the other variable decreases).

0: No correlation. The variables do not have a relationship with each other.

https://corporatefinanceinstitute.com/resources/knowledge/finance/correlation/ 1/6
10/19/2020 Correlation - Overview, Formula, and Practical Example

1: Perfect positive correlation. The variables tend to move in the same direction (i.e.,
when one variable increases, the other variable also increases).

One of the primary applications of the concept in nance is in portfolio management. A

thorough understanding of this statistical concept is essential to successful portfolio
optimization.

Correlation and Causation

Correlation must not be confused with causality. The famous expression “correlation does
not mean causation” is crucial to the understanding of the two statistical concepts.

If two variables are correlated, it does not imply that one variable causes the changes in
another variable. Correlation only assesses relationships between variables, and there may
be di erent factors that lead to the relationships. Causation may be a reason for the
correlation, but it is not the only possible explanation.

CFI’s Math for Corporate Finance Course explores the nancial mathematics concepts required
for nancial modeling.

How to Find the Correlation?

The correlation coe cient that indicates the strength of the relationship between two
variables can be found using the following formula:

Where:

rxy – the correlation coe cient of the linear relationship between the variables x and y

https://corporatefinanceinstitute.com/resources/knowledge/finance/correlation/ 2/6
10/19/2020 Correlation - Overview, Formula, and Practical Example

xi – the values of the x-variable in a sample

x̅ – the mean of the values of the x-variable

yi – the values of the y-variable in a sample

ȳ – the mean of the values of the y-variable

In order to calculate the correlation coe cient using the formula above, you must
undertake the following steps:

1. Obtain a data sample with the values of x-variable and y-variable.

2. Calculate the means (averages) x̅  for the x-variable and ȳ for the y-variable.

3. For the x-variable, subtract the mean from each value of the x-variable (let’s call this new
variable “a”). Do the same for the y-variable (let’s call this variable “b”).

4. Multiply each a-value by the corresponding b-value and nd the sum of these
multiplications (the nal value is the numerator in the formula).

5. Square each a-value and calculate the sum of the result

6. Find the square root of the value obtained in the previous step (this is the denominator
in the formula).

7. Divide the value obtained in step 4 by the value obtained in step 7.

You can see that the manual calculation of the correlation coe cient is an extremely
tedious process, especially if the data sample is large. However, there are many software
tools that can help you save time when calculating the coe cient. The CORREL function in
Excel is one of the easiest ways to quickly calculate the correlation between two variables
for a large data set.

Example of Correlation

John is an investor. His portfolio primarily tracks the performance of the S&P 500 and John
wants to add the stock of Apple Inc. Before adding Apple to his portfolio, he wants to assess
the correlation between the stock and the S&P 500 to ensure that adding the stock won’t
increase the systematic risk of his portfolio. To nd the coe cient, John gathers the
following prices for the last ve years (Step 1):
https://corporatefinanceinstitute.com/resources/knowledge/finance/correlation/ 3/6
10/19/2020 Correlation - Overview, Formula, and Practical Example

Using the formula above, John can determine the correlation between the prices of the S&P
500 Index and Apple Inc.

First, John calculates the average prices of each security for the given periods (Step 2):

After the calculation of the average prices, we can nd the other values. A summary of the
calculations is given in the table below:

https://corporatefinanceinstitute.com/resources/knowledge/finance/correlation/ 4/6
10/19/2020 Correlation - Overview, Formula, and Practical Example

Using the obtained numbers, John can calculate the coe cient:

The coe cient indicates that the prices of the S&P 500 and Apple Inc. have a high positive
correlation. This means that their respective prices tend to move in the same direction.
Therefore, adding Apple to his portfolio would, in fact, increase the level of systematic risk.

Related Readings

Thank you for reading CFI’s explanation of Correlation. CFI is the o cial provider of
the Financial Modeling and Valuation Analyst (FMVA)™ certi cation program, designed to
transform anyone into a world-class nancial analyst.

To keep learning and developing your knowledge of nancial analysis, we highly

recommend the additional CFI resources below:

Anchoring Bias

Dynamic Financial Analysis

Hypothesis Testing

Poisson Distribution

Financial Analyst Training

Get world-class nancial training with CFI’s online certi ed nancial analyst training
program!

Gain the con dence you need to move up the ladder in a high powered corporate nance
career path.

https://corporatefinanceinstitute.com/resources/knowledge/finance/correlation/ 5/6
10/19/2020 Correlation - Overview, Formula, and Practical Example

Learn nancial modeling and valuation in Excel the easy way, with step-by-step training.

https://corporatefinanceinstitute.com/resources/knowledge/finance/correlation/ 6/6