Level 02

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26. Correlation

The Correlation Coefficient

Pearson's correlation:
1. The correlation coefficient measures the strength and direction of correlation.
2. Best known is Pearons’s product-moment correlation coefficient and is denoted by r or is called
Pearson’s r.
3. It varies between +1 to -1
4. The interpretation is different for medical research, social, economic or financial time series data
5. In financial time series, interpretation is again different depending on whether we compare raw price
data or percentage change (Yields), as the direct calculation of the correlation based on absolute
prices tends to overestimate the correlation coefficient as relations between financial price series are
seldom linear.

Coefficient of determination.
1. The Coefficient of Determination r2 is the Square of Pearson's correlation coefficient.
2. It represents the percent of data that is the closest to the line of best fit.
3. In regression, the coefficient of determination is useful in determining how well the regression line
approximates the real data points.

Spearmans p.
1. The Best nonparametric correlation coefficient is Spearman's rank correlation coefficient and is
denoted by p(Rho).
2. It does not require the assumption that the variables are normally distributed but linearity is still an
assumption.
3. The main advantage is that it is not sensitive to outliers.

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Level 02
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Assumptions
1. Linearity
2. Normality
3. Outliers

Homoscedasticity
1. A set of random variables having the same variance is called homoscedastic.
2. Serious violation in homoscedasticity results in underemphasizing the person's coefficient.

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