Question

1. How is correlation measured?

2. What is the importance of correlation in investment theory?

3. In Excel use a function = CORREL (highlight the first array of data: Market Return, second array of data: Stock A return).

Year	Market Return	Stock A return
2010	-0.06	-0.01
2011	0.01	0.04
2012	0.05	0.05
2013	-0.03	0.027
2014	0.00	0.075
2015	0.10	0.08

Find the correlation coefficient. Explain what that number means regarding stock A and market rate of return.

Answer 1

1. Correlation is a measure of degree of relationship between two stocks and it can be measured by dividing Covariance of two stocks with product of standard deviation of these two stocks.

$\rho _{12} = \frac{Cov(1,2)}{\sigma _1*\sigma _2}$

2. Importance of Correlation in investment theory:

Correlation is very important to investment theory it is used to diversify the portfolio which helps to reduce the overall risk of portfolio. Correlation coefficient helps to construct minimum variance portfolio or optimal risky portfolio. Investor uses correlation measure for their asset allocation.

3.

Please refer to below spreadsheet for calculation and answer. Cell reference also provided.

C D NMEA Year 2010 2011 2012 2013 2014 2015 Market Return -0.060 0.010 0.050 -0.030 0.000 0.100 S tock A return -0.010 0.040 0.050 0.027 0.075 0.080 Correlation coefficient 0.8056 13 Market and Stock A is positively correlated which both market and stock A move in same direction but at differenct pace. 15

Cell reference -

D24 ✓ fx X B Year Market Return Stock A return 2010 2011 2012 -0.06 0.01 0.05 -0.01 0.04 0.05 0.027 0.075 0.08 2013 2014 2015 -0.03 0 0.1 Correlation coefficient =CORREL(C4:C9,D4:09) Market and Stock A is positively correlated which both market and stock A move in same direction but at differenct pace.

Hope this will help, please do comment if you need any further explanation. Your feedback would be highly appreciated.