Financial Correlation basically measures the relationship between the changes occurring in two or more variables at the same time. Correlation plays a major role in finance. According to the CAPM or Capital Asset Pricing Model, an increase in diversification can significantly increase the return to risk ratio. This is the reason why diversification is a word that is synonymous with Correlation, as in, the lower the correlation between the constituent holding, the low the risk will be of holding the combined portfolio.
Correlation is calculation by what is known as the ‘Correlation Coefficient’ which ranges from between -1 to +1. A correlation co-efficient of +1 is known as a perfect positive correlation. What this implies is that when one security shifts up or down, the other security will also shift accordingly in the same direction.
When the prices of two different securities move in a similar direction the securities are considered to be correlated. This also means that the relationship that exists between the two securities is a positive one the majority of the time.
On the flip side, perfect negative correlation basically means that if one security moves either upwards or downwards, the security that is perfectly negative correlated will move in the opposite direction. And if the correlation is ‘0’ there will be no correlation between the movements of both the securities. Both securities in this state will be completely random.
No-correlation securities move independently of one another with no apparent relationship towards each other. For instance, if the price of oil stocks and medical stocks move independently of each other they are said to have ‘0’ correlation or no-correlation. While perfect correlated securities is a rare occurrence in real life, it isn’t unheard of. No-Correlation is also important when it comes to portfolio diversification. For instance, when some securities of a particular portfolio seem to be losing money, other non-correlated securities will most likely either gain profits or will not move at all, reducing the losses of the investors.
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