Correlation

Question 1

What is correlation and why is important?

Answer 1

• Correlation s used to measure how closely the return of two assets move together.
• It is a number between 1 and -1.
• Postive correlation means that two assets tend to move in the same direction.
• Negative correlation means that two assets tend to move in opposite directions.
• Strong correlation would be a number above 0.5.
• Why is it important:
  
  • if a manager wishes to diversify a portfolio to reduce risk then combining assets with low correlations will help to reduce volatility.
  • Combining assets with negative correlation will reduce risk considerably but may also have an impact on dampening returns at the same time.

Question 2

What is the portfolio risk of a portfolio?

Answer 2

• Give the systematic risk and unsystematic risk the total risk of the portfolio is measured by the standard deviation.
• You square the standard deviation of the risk to find the variance, sum them, and then do the square root of the sume.
• Square them, sum them, square root it.
• Eg:
  

Answer 3

• Correlation = covariance / (STDEV of A x STDEV of B)
• = 0.003 / (0.11 X 0.06) = 0.45