Correlation in Financial Market
In statistics, correlation means two or more variables moving together. Correlation in financial investment industries is the relation between two financial securities moving with each other statistically. It is computed as the correlation coefficient which has the value that must fall between -0.1 to +0.1. The relationship strength of the two variables is demonstrated by the correlation coefficient and expressed numerically. A positive correlation indicates movements in the same direction & a negative correlation indicates movement in opposite direction. There are various types of correlation in financial industries used to relate two or more financial securities they are – Inverse correlation, cross-correlation, multiple correlations, etc.
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Why is Correlation Used in Financial Market?
The whole purpose of using correlation in research is to find out the relation between variables (i.e financial securities). Correlation can be used to build a well-diversified portfolio by reducing risk and also improving returns. It is ideal for individual securities, such as stocks, or it may evaluate general market correlations such as how asset classes or large markets are interrelated. Correlation may be used to gain an insight into the overall dynamics of the broad financial sector. By using correlation, a portfolio can be built with a diversified set of securities across multiple asset classes, which has low or negative correlation values. Hence, you can reduce the risk of exposure to a singular market shock.
Examples of Correlation in the Financial Market:
The purpose of most financial advisors and many investors is to find assets that are not closely related. Correlation is used in commodity and forex markets to see the relation between two underlying securities. For e.g, the relation between gold & silver can be seen to see whether they are positively correlated or negatively correlated. If two commodities are negatively correlated we can use it for hedging purposes. Similarly, the correlation between currencies can also be used to check the forex market.
- Correlation in the commodity market – The correlation between commodity markets is driven by common assets and additional commodities, but do not necessarily display strong levels of price-action association. Commodities are raw materials that are used interchangeably across businesses and offer no operational connection to the asset class.
The correlation exists mainly with intrinsic similarity & shared utility. For e.g, crude oil mainly correlates with Brent oil, which serves as the main benchmark for oil prices because both commodities can be refined into gasoline.
- Correlation in Stock Market – Companies in the same industry will correlate strongly during sector-wide turmoil such as monetary policy adjustments, or macroeconomic shifts. Certain large-cap stocks lend themselves through correlation through fund flow. Companies operating in the same sector may correlate highly during sector-wide disturbance for e.g. TCS & Infosys has a greater positive correlation in the stock market (NSE & BSE).
- Correlation in foreign exchange – The foreign exchange market is a great place to learn foreign policy and trade globally. Investors can actively trade in currencies of diff value for e.g., Us dollar currency can be traded with euros, etc and correlation can be made in the forex market. The value of the basic currency is specified in the quote currency but the cause of the price action of a single pair may be difficult to determine.
Advantages Of Correlation:
- Correlation helps us to know which two securities are correlated and if one gets affected how will the other react. It demonstrates the strength of a relationship between two values better than using covariance.
- Correlation helps to hedge risk if we invest in negatively correlated securities so if one security goes down others will go upwards. For e.g., gold and equity are negatively correlated so if the price of equity goes down we can hedge risk by investing in gold commodities.
- Although not easy to compute, even beginners can easily comprehend the correlation scale -1 to 1.
- A graph of the correlation coefficient will reflect patterns that are useful in deciding the future course of the value.
- It is also helpful for understanding the correlation of securities in a particular industry.
Disadvantages Of Correlation:
- Correlation indicates the strength of a partnership, but cannot demonstrate if the relationship is a cause-effect relationship.
- As with any estimation based on mean values, the average and therefore the correlation results – particularly with smaller data sets – can be skewed by typical values.
- A strong correlation is better seen when there is a linear relationship between the two values, but two values that have a nonlinear relationship may also have a correlation that cannot be seen in the computation of the coefficient.
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Choosing assets with low correlation with each other can reduce the risk of the portfolio. For E.g. The most common way to use a diversified portfolio of equity is to include bonds. Bonds and equity have a historically low degree of correlation with each other. Investors also use commodities as well as forex currency to diversify their portfolios. In commodities, gold & silver are often used to hedge for equities as they have a negative correlation with each other. In this way by investing in various securities that have low or negative correlation helps to diversify the portfolio and reduce the risk.
Author – Hariharan Krishnan
About the Author – Hariharan Krishnan is an undergraduate currently pursuing BAF and also pursuing FRM Course. He is passionate to learn about new things.