Correlation of Securities

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 What is Correlation?

Correlation (𝜌!,# ) is an alternative measure

of the relationship between securities.

You can think of it as an “extension” of the

covariance (𝜎!,# )

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 Recall the Covariance

The covariance measures the relationship

between securities by estimating their co-
variability.
(
1
𝑐𝑜𝑣(𝑟! , 𝑟" ) ≡ 𝜎#!,#" = . 𝑟! − 𝐸 𝑟! 𝑟" − 𝐸 𝑟"
𝑛−1
%&'

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 Limitation of the Covariance

The covariance tends to be a very small

number, making its interpretation quite
challenging.

It can also theoretically be any value, which

doesn’t help with interpretation either.

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 Correlation Bounds

Correlation (𝜌!,# ) is bounded between

−1 and +1 inclusive

This allows us to objectively understand and

comment on the strength of relationships

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 Interpreting the Correlation

Correlation Relationship between stocks 𝒋 and 𝒌

𝜌!,# = +1 Perfectly positively correlated

𝜌!,# = −1 Perfectly negatively correlated
𝜌!,# = 0 Completely uncorrelated

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 Interpreting the Correlation

Correlation Relationship between stocks 𝒋 and 𝒌

𝜌!,# = +1 If 𝑗 increases by 5%, 𝑘 will increase by 5%

𝜌!,# = −1 If 𝑗 increases by 5%, 𝑘 will decrease by 5%
If 𝑗 increases by 5%, 𝑘 could increase,
𝜌!,# = 0
decrease, or remain unchanged

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 Crucially, correlation does NOT imply
causality.

Just because 2 stocks are moving in the same

direction, it doesn’t mean one’s causing the
other to move.

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 Correlation ≠ Causality

Adapted from Vigen (2020), ‘Spurious Correlations’. Available [Online]: https://tylervigen.com/spurious-correlations

Original chart released under Creative Commons 4.0

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 Estimating the Correlation

Correlation is calculated by scaling the

covariance by the product of standard
deviations.
𝜎!,#
𝜌!,# =
𝜎! 𝜎#

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 Correlation

𝜎!,#
𝜌!,# =
𝜎! 𝜎#

Where:
𝜌!,# = Correlation between stocks 𝑗 and 𝑘
𝜎!,# = Covariance between stocks 𝑗 and 𝑘
𝜎! = Standard deviation (of stock 𝑗; subscript 𝑘 for stock 𝑘).

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 Correlation of an asset with itself

Importantly, the correlation of any asset

with itself is always equal to 1

That’s because the covariance of any asset

with itself is equal to its variance

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 Correlation of an asset with itself

𝜎!,"
𝜌!," =
𝜎! 𝜎"

𝜎!,!
𝜌!,! =
𝜎! 𝜎!

𝜎!)
𝜌!,! = =1
𝜎!)

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 Correlation Example

Imagine you hold a portfolio of 2 stocks, and

have the following information:
Stocks Betflix Inc. (BFLX) Lotify Tech (LOT)
Total risk (Std. Dev, 𝜎! ) 24.39% 31.94%
Covariance (𝜎"#$%,$'( ) 0.01792

What is the correlation between Betflix and

Lotify?

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 Correlation Example (Solution)

𝜎!,"
𝜌!," =
𝜎! 𝜎"

𝜎*+,-,,./
𝜌*+,-,,./ =
𝜎*+,- 𝜎,./

0.01792
𝜌*+,-,,./ = ≈ 0.23
0.2439×0.3194

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 Interpreting the Correlation

Correlation Strength of relationship

0.01 ≤ 𝜌!,# ≤ 0.5 Relatively weak

0.5 < 𝜌!,# < 0.8 Relatively strong

𝜌!,# ≥ 0.8 Strong

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 Summary

Correlation, similar to the covariance, measures the relationships

between securities.

The correlation is bounded between −1 and +1 inclusive, and is

estimated by:
𝜎!,)
𝜌!,) =
𝜎! 𝜎)

The correlation of any asset with itself is always equal to 1.

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 Now have a go
at the quiz!

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