FIN236 Topic03

3
TOPIC
3
Correlation, covariance and
causation
Overview 3.3
Topic learning outcomes .............................................................................................. 3.3
Required readings ........................................................................................................ 3.4
Further resources ........................................................................................................ 3.4
1 Covariance 3.4
1.1 Scatter plots .................................................................................................... 3.4
1.2 Covariance ....................................................................................................... 3.5
1.3 The variance-covariance matrix .......................................................................... 3.6
1.4 Importance of the sign of covariance ................................................................. 3.7
1.5 Mean and variance of a linear function of random variables ................................ 3.7
1.6 Variance and covariance of two linear functions of random variables ................... 3.8
1.7 Diversification and portfolio theory ..................................................................... 3.9
2 Correlation 3.10
2.1 The Pearson product-moment correlation formula ............................................. 3.11
2.2 Three correlation relationships ........................................................................ 3.12
2.3 Stability of correlation coefficients ................................................................... 3.16
3 Covariance and correlation matrices 3.18
3.1 Matrix forms representing covariance and correlation ....................................... 3.18
3.2 Using matrix forms to calculate volatility of share portfolios .............................. 3.19
4 Spearman rank correlation 3.22
4.1 Benefits of non-parametric correlation ............................................................. 3.24
4.2 Spearman rank correlation matrix .................................................................... 3.27
4.3 Portfolio risk and diversification ....................................................................... 3.28
4.4 The geometry of risk ....................................................................................... 3.28
5 Issues in correlation analysis 3.30
5.1 Correlation not causation ................................................................................ 3.30
5.2 Co-occurrence ................................................................................................ 3.30
5.3 Correlation only measures linear relationships ................................................. 3.31
5.4 Two viewpoints of data ................................................................................... 3.31
5.5 Why do data series display correlation? ........................................................... 3.32
5.6 Granger causality ........................................................................................... 3.35
5.7 The outlier problem in correlation .................................................................... 3.36
5.8 Partial correlation ........................................................................................... 3.37
6 Statistical significance 3.37
6.1 Sampling error ............................................................................................... 3.37
6.2 Confidence intervals and limits ....................................................................... 3.38
6.3 Statistical significance .................................................................................... 3.38
6.4 Correlation confidence intervals ...................................................................... 3.38
6.5 Statistically significant correlation estimate ..................................................... 3.39
6.6 The problem of heteroscedasticity ................................................................... 3.40
References 3.44
Suggested answers 3.44

3.3
Quantitative Applications in Finance | FIN236.SM1.8 Kaplan Higher Education
Overview
This topic examines the concepts of correlation and covariance and introduces Pearson correlation
and the Spearman rank correlation coefficients.
The aim of correlation analysis is to identify the degree to which a linear relationship exists
between two variables, and to measure the extent of the relationship.
As an example, if there is a strong correlation between the share price and earnings per share of
a company, then the two variables would be expected to move closely together in the future, and
any divergence would tend to be corrected over time by a change in the value of one or both of the
variables so that the relationship between them (in this case the price-to-earnings (PE) ratio) would
tend to revert (regress) to its historic mean level. (Regression will be covered in Topic 4).
There are, however, some important issues to bear in mind when using an established
relationship to predict future behaviour:
The ability to discriminate between those correlations that can be relied on to persist and
those that will not is a key part of the analysis.
Correlation is contemporaneous and explicitly not forecasting. Consider the following
statement, If it is windy my boat will sail well; if it is calm it will not. This is a very reliable
correlation, but it does not help forecast how I will sail tomorrow because there is no means
of absolutely knowing the weather beyond today. However, on the condition that tomorrows
weather is windy, whether or not the boat will sail well can be predicted. In order to make an
unconditional forecast of one variable, the cause and effect of related variables rather than
just historic correlation must be known.
Correlation does not imply causation i.e. a reliable correlation between two variables does
not mean there is (or is not) a causal relationship between the variables. Nor does it mean that
there is no causal relationship. Any causal relationship between the variables may be indirect,
or unknown, or hostage to the existence of another factor. And even where a causal
relationship exists between two correlated variables, in many cases it is impossible to tell the
direction of the causation, i.e. whether a change in A causes a change in B or vice versa.
This topic specifically addresses the following subject learning outcomes:
1. Evaluate the strengths and limitations of quantitative analysis techniques.
3. Explain the relationship and independence of factors influencing financial diversity,
performance and volatility.
Topic learning outcomes
On completing this topic, students should be able to:
analyse the factors affecting financial products identifying:
which are significant
which are positively or negatively inter-related
which contribute to diversification
which contribute to volatility
apply the statistical analyses of covariance, correlation and matrix algebra
explain the strengths and weaknesses of the Pearson and Spearman rank correlations
calculate the variance of a portfolio of many asset returns using the covariance matrix of asset
returns
explain the difference between causation, correlation and spurious correlation.
3.4
Required readings
All required readings are assessable content for this subject. Readings are accessible via the
eBook, a prescribed textbook, a Kaplan Library database or a website:
1. Clarida, RH 2007, Global perspectives: A great moderation, but global diversification is still a
great deal, PIMCO, Newport Beach, California.
2. Bauman, WS & Miller, RE 1994, Can managed portfolio performance be predicted?,
The Journal of Portfolio Management, vol. 20, no. 4, pp. 3140.
Further resources
Brainard, WC & Tobin, J 1968, Pitfalls in financial model building, American Economic
Association, vol. 58, no. 2, pp. 99122, viewed 19 March 2012, EBSCO Business Source
Corporate database.
Chiang, A 2005, Chapter 4: Linear models and matrix algebra, Fundamental methods of
mathematical economics, 4th edn, McGraw-Hill, New York, pp. 4881. Available on
Closed Reserve from the Kaplan Library.
Gujarati, DN 2003, Appendix B: Rudiments of matrix algebra, Basic econometrics, 4th edn,
McGraw-Hill Higher Education, Singapore.
Smith, G 1975, Pitfalls in financial model building: A clarification, American Economic Review,
June, vol. 65, issue 3, pp. 510516, viewed 19 March 2012, EBSCO Business Source
Corporate database.
1 Covariance
Covariance and correlation are used extensively to measure relationships among variables.
Unfortunately, the estimates are subject to sampling biases and misinterpretation, including
issues such as outliers, spurious relationships, sampling error, and heteroscedasticity. Alternative
measures can be used to derive the correlation by converting the data to ranks, or by deriving
confidence interval estimates.
1.1 Scatter plots
Key concept: Scatter plot
A scatter plot or scatter diagram is a graph of paired observations for two variables
(e.g. Y and X) and is used to illustrate the relationship between the variables.
For example, suppose yearly data is gathered for the past 10 years showing company sales
growth and GDP growth rates as shown in Table 1 below.
3.5
Table 1 Ten year company sales growth and GDP rates
Year Company sales growth (Y) GDP growth (X)
1 0.11 0.06
2 0.12 0.05
3 0.04 0.04
4 0.07 0.03
5 0.06 0.02
6 0.01 0.01
7 0.03 0.00
8 0.06 0.02
9 0.11 0.05
10 0.06 0.04
The table reports paired observations for company sales growth and economy growth for each of
past 10 years. For example, in Year 1, the broad economy (i.e. GDP) fell 6%. During that same
year, company sales dropped 11%. And, in Year 6, both the broad economy and company sales
both shrank 1%.
Figure 1 Scatter plot of company sales growth rate
Company sales growth rate
GDP growth rate
12%
12%
4%
4% 4% 8% 12% 8% 12%
4%
8%
12%

Notice that there is a positive relationship between company sales growth and broad economy
growth. The scatter slopes upwards and to the right. So, generally speaking, company sales
growth increases as the general economy grows, and vice versa.
1.2 Covariance
Key concept: Covariance
Covariance is a statistic used to measure the relationship between two variables.
Covariance ranges from negative infinity to positive infinity (i.e. it is unbounded). A positive
covariance indicates a positive relationship (such as the relationship illustrated in Figure 1 above),
a negative covariance indicates a negative relationship (a downward sloped scatter plot), and a
zero covariance indicates no relationship (a circular scatter plot). In a financial context, this may
be applied to find a measure of the degree to which asset returns vary in relation to one another.
3.6
Consider two random variables x and y. Their means are
x
and
y
, and standard deviations given
by
x
and
y
respectively. The covariance between x and y is given by:
( ) ( )
( ) ( )
1
E
1
1
xy x y
n
x y
i
x y
x y
n

=
(
=

=

where n is the sample size.
The denominator is n 1 rather than n, in order to make the measure unbiased.
(Note: In Excel, the COVAR() function uses n in the denominator.)
The covariance of x and y is also written as Cov(x,y) =
xy
. (Note: The variance of x is
Var(x) =
xx
=
2
x
.)
The notation
xx
has a double x subscript, and represents the covariance of x with itself (i.e. the
variance of x). However, since
x
is generally used for standard deviation, the notation is not often
used.
The sign of covariance indicates the direction of covariation between x and y. A positive
covariation means that the variables tend to move up together and down together, while a
negative covariation means the variables tend to move in opposite directions.
1.3 The variance-covariance matrix
Key concept: Variance-covariance matrix
The variance-covariance matrix can be thought of as a square table arranged in a
fixed number of rows and columns, conveniently providing variances and covariances
for multiple variables. Variances are reported down the diagonal and covariances are
reported off the diagonal.
For example, the covariance between variables i and j is reported at the intersection of row i and
column j. The covariance of i with itself is equal to its variance and is the intersection of row i with
column i, causing the diagonals of the variance-covariance matrix to equal the variances of the
associated variables.
The variance-covariance matrix for three variables, 1, 2, and 3 is represented as follows:
2
1 1,2 1,3
2
2,1 2 2,3
2
3,1 3,2 3
s s s
s s s
s s s
(
(
(
(
(
(

Note that the covariance is symmetric in that the covariance between variables 1 and 2,
1,2
,
equals the covariance between variables 2 and 1,
2,1
. Therefore,
1,2
=
2,1
. More generally,
i,j
=
j,i
.
3.7
Example: Variance-covariance matrix
Interpret the following variance-covariance matrix of annual returning between funds 1,
2 and 3:
0.04 0.06 0.08
0.09 0.10
0.16
(
(
(

From the table, determine the variances for funds 1, 2, and 3 and the covariances
between funds 1 and 2, funds 1 and 3, and funds 2 and 3.
The answer would be:
Variance for Fund 1 = 0.04
Covariance between funds 1 and 2 = 0.06
The variance-covariance matrix is symmetrical about its diagonal. The lower and upper
portions of the matrix are identical:
0.04 0.06 0.08
0.06 0.09 0.10
0.08 0.10 0.16
(
(
(

1.4 Importance of the sign of covariance
As explained earlier, the covariance is unbounded, ranging from negative to positive infinity.
The magnitude depends on the unit of measurement for the two variables. Therefore, the actual
magnitude of the covariance provides little insight into the strength of the relationship. The most
important information provided by the covariance is its sign (positive versus negative), indicating
whether the variables exhibit a positive or negative relationship on average.
1.5 Mean and variance of a linear function of random variables
The following formulas are fundamental in understanding the idea of portfolio diversification.
Let x, y and z be random variables with means and variances respectively of
x
,
y
,
z
, and
2 2 2
, ,
x y z
. Furthermore, Cov(x,y)=
xy
, Cov(x,z)=
xz
and Cov(y,z)=
yz
. Let w
1
, w
2
, w
3
, a and b
be constant real numbers. Then the following relationships hold:
1 2 3 1 2 3
( )
x y z
E w x w y w z a w w w a + + + = + + +
2 2
1 2 1 2 1 2
2 2 2 2
1 2 1 2
( ) ( ) ( ) 2 ( , )
2
x y xy
Var w x w y w Var x w Var y w w Cov x y
w w w w
+ = + +
= + +

3.8
Proof: Var(w
1
x + w
2
y)
( ) ( )
( ) ( ) ( )
( )
( ) ( ) ( )
( ) ( ) ( ) ( )
( )
( ) ( ) ( ) ( )
2
1 2 1 2
2
1 2 1 2
2
1 2 1 2
2
1 2
2
2 2 2
1 2 1 2
2
2 2 2
1 2 1 2
2 2 2 2
1 2 1 2
2
2
2
x y
x y
x y x y
x y x y
x y xy
E w x w y E w x w y
E w x w y w E x w E y
E w x w y w w
E w x w y
E w x w y w w x y
w E x w E y w w E x y
w w w w

= + +
= +
= +
= +
= + +
= + +
= + +

1.6 Variance and covariance of two linear functions of random
variables
The following formulas show how to work out the variance and covariance of two linear functions
of random variables.
Given that:
A = w
1
x + w
x
y + w
3
z + a
Var(A) =
2 2 2 2 2 2
1 2 3 1 2 1 3 2 3
2 2 2
x y z xy xz yz
w w w w w w w w w + + + + +
Given that:
B = w
1
x + w
2
y + a
C = w
3
z + b
Cov(B,C) =
1 3 2 3 xz yz
w w w w +
Proof:
Var(A) = E(A E(A))
2

=
2
1 2 3 1 2 3
( - )
x y z
E w x w y w z a w m w m w m a + + +
=
2 2 2 2 2 2
1 2 3 1 2
1 3 2 3
( - ) ( - ) ( - ) 2 ( - )( - )
2 ( - )( - ) 2 ( - )( - )
x y z x y
x z y z
w E x m w E y m w E z m w w E x m y m
w w E x m z m w w E y m z m
+ + +
+ +

=
2 2 2 2 2 2
1 2 3 1 2 1 3 2 3
2 2 2
x y z xy xz yz
w s w s w s w w s w w s w w s + + + + +
Cov(B,C) = E(B E(B))(C E(C))
=
1 2 1 2 3 3
[ ][ ]
x y z
E w x w y a w m w m a w z b w m b + + +
=
1 2 3
[ ( ) ( )][ ( )]
x y z
E w x m w y m w z m +
=
1 3 2 3
( ) ( ) ( ) ( )
x z y z
w w E x m z m w w E y m z m +
=
2 3 2 3 xz yz
w w s w w s +

3.9
In the above formulas a, b, w
1
, w
2
, and w
3
are constants and x, y and z are random variables.
The expected value of a constant is simply the constant itself. However, the variance of a
constant is zero, as the constant does not vary. These formulas are relevant to finance and are
used to work out the variance and covariance of two portfolios consisting of overlapping assets.
1.7 Diversification and portfolio theory
Since a portfolio of assets is simply a weighted average of different assets, the return of a
portfolio is also a weighted average of the asset returns. If the asset returns are random variables
with a similar mean and variance, then the advantage of holding a portfolio of different assets
comes from having portfolio returns with a similar mean to those of the assets, but a smaller
variance. This is the diversification benefit of portfolio theory. It relies on the fact that there is a
less than perfect correlation between the underlying assets, which is reflected in the variance of
portfolio returns.
The variance of portfolio returns is shown in the example below. It is based on the variances and
covariances of underlying asset returns.
Example: Calculating the variance of portfolio returns
Assume the construction of a portfolio is made up of a proportion w
1
in shares and w
2

in bonds. The returns from each asset class have the following characteristics:
Expected mean return from shares is 8% p.a.
Expected mean return from bonds is 5% p.a.
Standard deviation of returns from shares is 9% p.a.
Standard deviation of returns from bonds is 6% p.a.
Covariance of shares and bonds returns is zero.
Use the formula:
( )
2 2 2 2
1 2 1 2 1 2
2
x y xy
Var w x w y w w w w + = + +
The variance of the portfolio with proportion w
1
in shares and 1 w
1
in bonds is
given by:
2 2 2 2
1 1 1 1
2 2
1 1
2 2
1 1 1
2
1 1
( 0.09) (1 ) ( 0.06) 2 (1 ) 0
0.0081 (1 ) 0.0036
0.0081 0.0036 0.0072 0.0036
0.0036 0.0072 0.0117
w w w w
w w
w w w
w w
+ +
= +
= + +
= +

Since w
2
must equal 1 w
1
in this case, the expected return on the portfolio is given
by:
0.08 w
1
+ 0.05 (1 w
1
)
= 0.05 + 0.03w
1

Table 2 shows the expected return and standard deviation of the portfolio as the weight
in shares is progressively increased, i.e., w
1
= 0.1, 0.2, 0.3, , 1.0. Raw figures for
this table are in the Return and deviation tab of the Excel spreadsheet.
3.10
Table 2 Expected return and standard deviation of the portfolio from w
1

Weight (w
1
) Expected return Variance Standard deviation
0.0 5.0% 0.36% 6.0%
0.1 5.3% 0.30% 5.5%
0.2 5.6% 0.26% 5.1%
0.3 5.9% 0.25% 5.0%
0.4 6.2% 0.26% 5.1%
0.5 6.5% 0.29% 5.4%
0.6 6.8% 0.35% 5.9%
0.7 7.1% 0.43% 6.6%
0.8 7.4% 0.53% 7.3%
0.9 7.7% 0.66% 8.1%
1.0 8.0% 0.81% 9.0%
Note: When w
1
= 0.3, the portfolio has an expected return of 5.9% and a standard
deviation of 5.0%. The standard deviation is lower than that of either shares or bonds,
and the ratio of expected return to standard deviation (or riskreturn ratio) is
significantly better than for either shares or bonds alone.
Required reading 1
Clarida, RH 2007, Global perspectives: A great moderation, but global diversification
is still a great deal, PIMCO, Newport Beach, California.
The above reading provides insight into diversification from a global perspective.
2 Correlation
In statistics, correlation is a measure of the linear relationship between two random variables
in terms of both the strength and direction of the relationship. The strength of the correlation
between two variables determines how well the value of one of the variables can be predicted
from the value of the other.
The relationship is linear when any change in the independent variable results in a change in the
dependent variable. Such a relationship, plotted on a graph, results in a straight line.
However, in general terms, correlation can refer to any kind of relationship, i.e. other kinds as well
as linear.
Key concept: Using correlation
By combining asset classes that are not correlated with each other, a portfolio can be
produced with better riskreturn characteristics than either asset class alone.
This effect is extremely powerful, and occurs whenever the asset classes are
not perfectly correlated with one another.
It is sometimes difficult to interpret a covariance because the scale of measurement
or dispersion of each of the variables affects the covariance estimate. For this
reason, the correlation coefficient is often used instead.
3.11
2.1 The Pearson product-moment correlation formula
The major weakness of covariance is that it is useless as a measure of the strength of the
relationship between two variables. To correct the problem, it is common to scale (divide)
the covariance by the product of the standard deviations of the two variables.
Key concept: Pearson correlation
The Pearson product-moment correlation coefficient or Pearson correlation is the
measure of the correlation between two variables giving a value between +1 and 1.
Correlation coefficients are particularly useful when more than one random variable is involved.
This is the case with a portfolio of assets because the volatility of the portfolio returns consists of
the volatilities of the underlying asset returns and the correlations of these returns. The Pearson
correlation is shown in Formula 1 below.
Formula 1
xy
xy
x y

=
where:
, the symbol for the correlation coefficient, is the Greek letter rho
xy
= the covariance between x and y
x
= standard deviation of x
y
= standard deviation of y.
In Formula 1, correlation adjusts for the dispersion of each variable by dividing by each of the
standard deviations. The correlation coefficient normalises the covariance. Unlike covariance,
correlation is easier to interpret because it is independent of the unit of measurement of the
underlying variables. This produces a measure that always lies between 1 and +1. Therefore,
while the covariance is useless as a measure of the strength of relationship between two
variables, the correlation is a very useful measure of the strength of relationship.
Note that Formula 1 can be rearranged to express the covariance as a function of correlation and
standard deviations. This is important if there are views of what future relationships might be and
if those views are to be imposed on a covariance estimate.
For instance, the historic correlation between two variables might be 0.45, but due to new
information it is believed that it will increase to 0.60 going forward. Since covariance is difficult
to interpret if the variables have different units of measurement, it is easier to express a view
through correlation and the standard deviations of the variables and then work out the implied
covariance.
Like all quantitative calculations, correlation and covariance should not be used carelessly.
The context under which the variables are linked to each other must also be studied.
3.12
2.2 Three correlation relationships
There are three correlation relationships: positive, negative and none.
Correlations that are close to +1 indicate that a strong positive linear relationship exists between
the two variables, i.e. all data lies on a perfect straight line with a positive slope. Correlations that
are close to 1 indicate that a strong negative linear relationship exists between two variables,
i.e. the data lies on a straight line with a negative slope. Correlations that are close to zero
indicate that no linear relationship exists between the two variables, in which case the variables
are said to be uncorrelated or independent.
Illustrations of strong positive, negative, and no linear relationships are provided in the scatter
plots in Figures 2 through 4 below.
Figure 2 A strong positive linear relationship
y
x

Figure 3 Strong negative linear relationship
y
x

Figure 4 No linear relationship
y
x

3.13
In Figure 2, the correlation is close to +1, indicative of a strong positive linear relationship, and in
Figure 3, the correlation is close to 1, indicative of a strong negative linear relationship. If all the
points fell directly on an upward sloping line in Figure 2, the correlation would equal exactly 1,
in which case we would say the variables had perfect positive correlation. If all the points fell
directly on a downward sloping line in Figure 3, the correlation would equal exactly 1, in which
case we would say the variables had perfect negative correlation. If the scatter plot forms circular
pattern (Figure 4), the correlation equals zero, indicating that there is no linear relationship
between the two variables. Note that the correlation gives an indication of the strength of the
linear relationship and does not provide information regarding non-linear relationships that may
exist between the variables.
Example: Correlation between two variables
Rate of return data are provided below for two stocks, X and Y. Derive the correlation
between the two sets of returns:
Outcome Xi Yi
1 0 0.40
2 0.20 0.20
3 0.40 0
Answer:
Assuming covariance between X and Y equals 0.04 and mean returns equal 0.20 for
both X and Y, theres just one last step to take to derive the correlation: compute the
standard deviations for both X and Y:
Standard deviation for X:
X
=
2
( )
1
i
X X
n

Calculations for the standard deviations are illustrated below:
Outcome X
i
( )
i
X X
( )
2
i
X X
1 0 0.20 0.04
2 0.20 0 0
3 0.40 +0.20 0.04
Standard deviation for X:
X
=
2
( )
0.04 0 0.04
1 2
i
X X
n
+ +
=
= 0.20
The standard deviation for Y will also equal 0.20 (since the returns observed for Y are
the same as those observed for X, although in different time periods). Therefore,
the correlation between the two stock return series is:
r
X,Y
=
0.04
0.20 0.20
= 1.0
Therefore, stocks X and Y are perfectly negatively correlated.
3.14
Apply your knowledge 1: Calculating variance and correlation of stock returns
Consider the following hypothetical monthly returns in Table 3 from January 2011 to
December 2012.
Table 3 Monthly returns (% per month)
DATE AMP ASX CBA GPT NAB QAN
ALL
ORDINARIES
Jan-11 6.90% 7.48% 0.00% 1.22% 4.57% 2.23% 3.64%
Feb-11 4.62% 7.07% 0.45% 2.47% 8.26% 0.73% 0.04%
Mar-11 0.93% 0.74% 1.00% 0.48% 2.78% 13.66% 4.28%
Apr-11 3.80% 0.46% 3.75% 1.69% 0.24% 2.26% 2.35%
May-11 1.40% 7.15% 8.13% 3.10% 6.70% 8.96% 4.51%
Jun-11 4.33% 6.82% 2.85% 6.63% 0.20% 6.03% 1.24%
Jul-11 1.31% 0.43% 0.88% 4.15% 2.10% 3.04% 1.53%
Aug-11 0.44% 0.86% 2.05% 1.11% 1.17% 12.79% 2.48%
Sep-11 1.21% 1.52% 0.07% 2.84% 1.05% 13.66% 0.65%
Oct-11 6.26% 10.79% 4.26% 0.43% 4.03% 8.44% 4.69%
Nov-11 0.11% 2.82% 0.57% 9.32% 2.62% 16.75% 2.03%
Dec-11 6.43% 4.81% 4.32% 8.53% 3.11% 5.45% 3.35%
Jan-12 3.66% 0.66% 1.13% 2.32% 0.05% 3.26% 2.01%
Feb-12 1.53% 10.42% 0.16% 7.68% 0.15% 4.45% 1.02%
Mar-12 0.78% 5.14% 0.60% 2.18% 0.10% 1.94% 2.79%
Apr-12 3.47% 9.09% 4.97% 0.20% 6.44% 1.33% 3.00%
May-12 2.29% 1.25% 5.00% 3.84% 1.07% 7.14% 2.98%
Jun-12 0.10% 0.21% 0.27% 9.34% 3.57% 1.75% 0.49%
Jul-12 0.59% 0.72% 1.79% 3.22% 6.48% 2.50% 1.95%
Aug-12 4.57% 5.40% 1.64% 5.99% 4.12% 2.79% 0.98%
Sep-12 0.19% 15.84% 2.25% 6.69% 0.58% 0.00% 5.32%
Oct-12 3.32% 6.70% 9.06% 9.41% 8.54% 5.91% 3.01%
Nov-12 0.49% 1.66% 3.01% 6.28% 11.14% 1.02% 2.74%
Dec-12 1.87% 7.27% 0.92% 6.70% 1.33% 7.01% 2.62%
See the Monthly returns tab in the Excel spreadsheet.
Using the values from Table 3, complete Tables 4 and 5 by:
(a) calculating the variance for the monthly returns for each of the six companies
in Table 3 over the two years (2006 and 2007) and writing your answers in
Table 4
(b) calculating the correlation coefficient for each pair of companies over the
two years (2011 and 2012) and writing your answers in Table 5.
3.15
Table 4 Variance for monthly returns
Stock Variance for monthly returns
AMP
ASX
CBA
GPT
NAB
QAN
Table 5 Correlation matrix of stock returns
Correlation AMP ASX CBA GPT NAB QAN
AMP
ASX
CBA
GPT
NAB
QAN
Discuss this: Table 6 correlations for full sample
Consider the following correlations in Table 6 from January 2011 to December 2012.
Table 6 Correlations
Stock Correlation with All Ords
AMP 0.33
ASX 0.57
CBA 0.72
GPT 0.36
NAB 0.60
QAN 0.29
What conclusions do you draw about the correlations of stock returns with
All Ordinaries Index (All Ords) returns?
Go to the Discussion Forum in the Subject Room and follow the discussion thread
called DT: Table 6 correlations for full sample and participate in the discussion
online.
Apply your knowledge 2: Correlations for two subsamples
Create two tables similar to Table 6 above, using 2006 data in one table and 2007
data in the other table.
Your new tables now represent the correlation matrix of the six stocks over two years
(2011 and 2012). Compare the results. How stable are correlations over time?
3.16
In considering Apply your knowledge 1 and 2 activities, the key points to note are as follows:
Correlations may change over time.
Stock returns tend to be positively correlated with the All Ords returns. (The correlations chart
shows that the correlations of the All Ords returns with individual stock returns are positive
over the two-year period from 2011 to 2012. The correlations with All Ords in year 2006 for
AMP, ASX and CBA are higher than those in year 2011. However, the correlations with the
All Ords in year 2006 for GPT, NAB and QAN are lower than those in year 2012.)
Some individual stock returns are positively correlated and some are negatively correlated
with each other.
Both the correlation and covariance matrices are symmetric matrices. The elements,
on opposite sides of the matrix diagonal, mirror each other. This is critically important
for matrix calculations of portfolio volatility.
2.3 Stability of correlation coefficients
Correlation coefficient ( ) is a poor guide when determining whether an association between x
and y is statistically significant, or whether one correlation is significantly stronger than another.
This is because is dependent on the underlying distributions of x and y, but they are not taken
into account in its calculation as, under the null hypothesis, correlation is zero and there is no
further assumption on the distribution of x and y.
In fact, the interpretation of can be completely meaningless if the underlying joint probability
distribution of x and y is too different from a bi-variate normal distribution.
Table 7 shows, for different numbers of monthly data, the probabilities of various non-zero
correlations occurring when x and y are independent and identically normally distributed:
x, y ~ NID(1, 0.5), where NID stands for normally and independently distributed and where
correlation between x and y should be 0%. This result is important when deciding the amount of
data to use in calculating accurate correlations and how much importance to place on any
published correlations.
Table 7 Probabilities* of various non-zero Pearson correlations
Number of years of monthly data simulated
1Y 2Y 3Y 4Y 5Y 6Y
Correl( )
2
=
0% 53.5% 71.0% 79.0% 90.5% 88.5% 94.5%
10% 25.0% 24.5% 19.5% 8.5% 10.0% 5.5%
20% 10.5% 3.5% 1.5% 1.0% 1.5% 0.0%
30% 7.0% 1.0% 0.0% 0.0% 0.0% 0.0%
40% 2.5% 0.0% 0.0% 0.0% 0.0% 0.0%
50% 0.5% 0.0% 0.0% 0.0% 0.0% 0.0%
60% 1.0% 0.0% 0.0% 0.0% 0.0% 0.0%
70% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%
80% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%
90% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%
100% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%
* Constructed by Monte Carlo sampling. The values are approximate only.
See the Non-zero Pearson tab in the Excel spreadsheet.
3.17
For instance, with one year (12 months) of monthly data (under column 1Y), a correlation square
of 30% will occur by chance 7% of the time. Thus, it is difficult to infer anything reliable from this
type of correlation. However, with six years under column 6Y (with 72 months of data), the
probability falls from 7% to 0% and the correlations based on this dataset would be a much more
reliable result.
Remember that the values in Table 7 only apply if the underlying joint probability distribution is
bi-variate normal.
Although it is often assumed that financial data is normally distributed, this assumption rarely
stands up to empirical testing. Thus, the normality assumption underlying the table would not hold
with most real financial data. These simulated results do provide some insight into the reliability
of calculated correlation values with different amounts of data the size of some of the
probabilities is surprisingly high.
Apply your knowledge 3: Spurious correlation coefficients
This application is based on Monte Carlo sampling under uniform distribution between
0 and 1. (Monte Carlo sampling was described in Topic 1 and an Excel example given
in Topic 2.)
The purpose of this activity is to illustrate the high incidence of spurious correlations
between two samples of random numbers, especially when the sample size is small.
1. Enter = RAND( ) in cell A1, then copy and paste this to cells A2 to A12.
You have generated 12 random numbers under the uniform distribution between
0 and 1.
2. Copy and paste cells A1 to A12 to B1 to B12.
You now have a second column of 12 random numbers.
3. Enter = CORREL(A1:A12, B1:B12) in cell B14.
This is the correlation between the numbers in the first column and those in the
second column. There is in fact no systematic correlation as the numbers are
random, so you would expect a number close to zero.
4. Repeatedly press F9 and look at cell B14. When you press F9 you are generating
two new columns of numbers and you will generate a different correlation.
If you keep repeating the experiment you may be surprised at the high correlations
you get from time to time.
If you repeat the whole exercise with significantly more than 12 numbers in the
columns, you should find that the correlations reduce.
Discuss this: Spurious correlation coefficients
In Apply your knowledge 3, why do the correlations reduce if there are significantly
more than 12 numbers in the columns?
called DT: Spurious correlation coefficients and participate in the discussion online.
3.18
3 Covariance and correlation matrices
When dealing with more than two random variables, it is common and more convenient to use
matrices to represent covariance and correlation. This is because covariance and correlation exist
for every pair of random variables.
The following references provide useful information on matrix algebra.
Further resources
Chiang, A 2005, Chapter 4: Linear models and matrix algebra, Fundamental
methods of mathematical economics, 4th edn, McGraw-Hill, New York, pp. 4881.
Available on Closed Reserve from the Kaplan Library.
Gujarati, DN 2003, Appendix B: Rudiments of matrix algebra', Basic econometrics,
4th edn, McGraw-Hill Higher Education, Singapore.
3.1 Matrix forms representing covariance and correlation
Consider the three random variables x, y and z. The covariance matrix can be described as
follows:
Covariance matrix:
xx xy xz
yx yy yz
zx zy zz

(
(
(
(

The correlation matrix
Similar to the variance-covariance matrix, the correlation matrix can be thought of as a square
table arranged in a fixed number of rows and columns, conveniently providing correlations for
different pairs of variables. The correlation between variables i and j is reported in row i and
column j. All correlations down the diagonal will equal one. That is, the correlation of variable i
with itself is reported in row i column i. The correlation of any variable with itself must equal one.
The correlation matrix for three random variables x, y and z is represented as follows:
Correlation matrix:
xy xz
yx yz
zx zy
1
1
1

(
(
=
(
(

Note that, like the variance-covariance matrix, the correlation matrix is also symmetric about its
diagonal. That is, the correlation between variables 1 and 2, r
1,2
, equals the correlation between
variables 2 and 1, r
2,1
. Therefore, r
1,2
= r
2,1
. More generally, r
i,j
= r
j,i
.
3.19
Example: Deriving and interpreting a correlation matrix
From the following variance-covariance matrix of annual returns between funds 1, 2,
and 3, derive and interpret the correlation matrix.
0.04 0.06 0.08
0.09 0.10
0.16
(
(
(
(
(

Answer:
The matrix reports variances down the diagonal and covariances off the diagonal.
To derive standard deviations, we must take the square root of the variances:
for Fund 1 = 0.04 = 0.20
for Fund 2 = 0.09 = 0.30
for Fund 3 = 0.16 = 0.40
Therefore, the correlations equal:
r
1,2
=
1,2
1 2
0.06
0.20 0.30

=

=+1.0
r
1,3
=
1,3
1 3
0.08
0.20 0.40

=

=1.0
r
2,3
=
2,3
2 3
0.10
0.30 0.40

=

=+0.83
The correlation matrix for the three funds is:
1,2 1,3
2,1 2,3
3,1 3,2
1 1 1 1
1 1 1 0.83
1 0.83 1 1
r r
r r
r r
( (
(
(
(
= (
(
(
(
(

3.2 Using matrix forms to calculate volatility of share portfolios
Key concept: Volatility
Volatility is the variation of a variable over a specific time period (1 year). Volatility is
backward looking (i.e. past volatility is no indicator of future volatility).
Matrix forms come into play when calculating the volatility of the return of a portfolio of shares.
3.20
Let:
1
2
N
R
R
R
R
(
(
=
(
(

= Column vector of asset returns for N assets.

and
1
2
N
w
w
w
w
(
(
=
(
(

= Column vector of asset weights for N assets.

The return of a portfolio of N shares can be calculated as the weighted sum of the returns of each
asset:
Portfolio return =
1
N
i i
i =
w R
= w R

where:
w
denotes the transpose of w from a column vector to a row vector.
In finance, the term volatility usually means annualised standard deviation, which is the square
root of annualised variance.
The variance of returns of a portfolio can be defined as follows:
Var( w R
) = w
R
w
where:
R
= the covariance matrix of the asset returns.
These matrix formulas are simply convenient ways to represent the more traditional arithmetic
formulas. If the vector R is based on monthly returns, then the variance of monthly returns can be
annualised by multiplying 12 so that volatility=sqrt[12*Var(wR)]
For example, with two asset classes (N = 2):
Portfolio return = w
1
R
1
+ w
2
R
2

= | |
1 2
w w
1
2
R
R
(
(
(

Portfolio variance =
2 2 2 2
1 1 2 2 1 2 12
2 w w w w + +
= | |
1 2
w w
11 12 1
21 22 2
w
w

( (
( (
( (

For three asset classes (N = 3):
Portfolio return = w
1
R
1
+ w
2
R
2
+ w
3
R
3
= | |
1 2 3
w w w
1
2
3
R
R
R
(
(
(
(
(

3.21
Portfolio variance =
2 2 2 2 2 2
1 1 2 2 3 3
w w w + +

1 2 12
2w w +

1 3 13
2w w +

2 3 23
2w w +
= | |
1 2 3
w w w
11 12 13 1
21 22 23 2
3 31 32 33
w
w
w

( (
( (
( (
( (
( (

Example: Estimating the absolute volatility of a portfolio
Table 8 shows the weighting of four stocks in a portfolio.
Table 8 Portfolio weightings
Stock Weighting
STK1 25%
STK2 25%
STK3 25%
STK4 25%
The covariance matrix of the returns of the stock is:
R
=
0 0036 0 0010 0 0062 0 0003
0 0010 0 0034 0 0032 0 0011
0 0062 0 0032 0 0211 0 0024
0 0003 0 0011 0 0024 0 0026
. . . .
. . . .
. . . .
. . . .
(
(
(
(

The variance of the portfolio return is then calculated as:
Var(Portfolio) =
R
w w

= 0.003694 per month.
where w = [0.25 0.25 0.25 0.25]
(You multiply the row vector (0.25 0.25 0.25 0.25) into the covariance matrix to get
another row vector (0.002775 0.002175 0.008225 0.001600). You then multiply this
row vector into a column vector TRANSPOSE(0.25 0.25 0.25 0.25) to get 0.003694 per
month.)
Remember that volatility (annualised standard deviation) is the square root of
annualised variance. Also, it is usual in the finance industry to express portfolio
volatility as an annualised quantity. To annualise a variance based on monthly data,
it is assumed that variance increases linearly with time, which means that annual
variance is 12 times monthly variance. Therefore, using the results above, the annual
volatility of the portfolio would be calculated as follows:
Annual volatility = (0.003694 12)
0.5

= 21.06%
Note: This implies the standard deviation increases linearly with the square root of
time.
3.22
Apply your knowledge 4: Calculation of portfolio variance using portfolio weightings
Calculate the volatility for the portfolio with weightings in Table 9, using the returns
data from Table 2.
Table 9 Portfolio weightings
Stock Weighting
AMP 50%
ASX 10%
CBA 10%
GPT 10%
NAB 10%
QAN 10%
4 Spearman rank correlation
The Pearson correlation coefficient is sensitive to departures in the data away from the normal
distribution and, in particular, to outliers in the data. Outliers cause the correlation to drop toward
zero, in which case the correlation is not a proper representation of the relationship across the
majority of the paired observations in the data series. The uncertainty in interpreting the
significance of the Pearson correlation coefficient (a parametric statistic) led to the search for
alternative non-parametric correlation statistics, in which data are not drawn, or assumed to be
not drawn, from a given probability distribution. One of the non-parametric correlation statistics is
the Spearman rank correlation coefficient. This section discusses the theory and application of
the Spearman rank correlation methodology.
Key concept: Spearman rank correlation
The Spearman rank correlation replaces the values of each random variable with their
rank among all other values from the same sample (resulting in two sets of numbers
drawn from the uniform distribution). The rank correlation is then simply a matter
of applying the Pearson correlation formula to the ranks of the data rather than to the
data values themselves.
There is a slight loss of information in calculating rank correlation, but this is easily outweighed
by a major advantage the significance of rank correlations can be tested exactly because the
distribution of r
s
is known.
To calculate the Spearman rank correlation, convert each observation in both data series
(i.e. X and Y) to a rank with the lowest observation in each series equalling one. If two or more
observations within a series are equal, the average rank is used. Then, the Spearman rank
correlation coefficient r is defined as:
( )
2
1
2
6
1
1
n
i
i
s
d
r
n n
=
=

where:
d = the difference in the ranks
n = the number of pairs of observations
if r
s
= +1, then there is perfect positive correlation in the ranks
if r
s
= 1, then there is perfect negative correlation in the ranks.
3.23
As with all correlation measures, 1 r
s
1.
With ranked data, the average value of each variable must be
( ) 1 + 2 + 3 ++ n
n
and if there are
no tied ranks, the standard deviation can also be figured out in advance. Due to these constraints
on the data, the Spearman rank correlation coefficient simplifies to:
( )
( )
2
1
2
6
1
1
n
i i
i
x y
R
n n
=

=

where:
( )
2
i i
x y
is the sum of the squared deviations between the two ranks x and y.
Example: Spearman rank correlation coefficient
Table 10 shows the mid-semester and final exam scores of five students:
Table 10 Mid-semester and final exam scores
Student Mid-semester exam Final exam
Score Rank (x) Score Rank (y)
CC
75 3 84 1
JG
56 4 69 4
JL
25 5 49 5
SR
78 1 75 3
JV
76 2 83 2
Instead of estimating the parameters of a regression equation using the scores, the
ranks in Table 10 can be used as follows:
Table 11 Mid-semester and final ranks
Mid-semester rank (x) Final rank (y)
3 1
4 4
5 5
1 3
2 2
For the data in Table 11:
( )
2
i i
x y
= ( ) ( ) ( ) ( ) ( )
2 2 2 2 2
3 1 4 4 5 5 1 3 2 2 + + + +
= 8
So that:
6( 8)
1
5( 25 1)
0 6
R

.
=
=

Ranks can be easily obtained from unsorted data using the Excel = RANK() function.
3.24
Example: Calculating the Spearman rank correlation
Cumulative rates of return are provided for four countries over two 10-year intervals.
Derive and interpret the Spearman rank correlation.
19801989 19901999
Country A 100% 24%
Country B 75% 25%
Country C 50% 40%
Country D 25% 30%
Answer:
First, convert the rates of return to numerical ranks.
19801989 19901999
Country A 4 1
Country B 3 2
Country C 2 4
Country D 1 3
Second, calculate d
2
for each county and sum to determine the cumulate d.
19801989 19901999 d
i
d
2
i
Country A 4 1 3 9
Country B 3 2 1 1
Country C 2 4 2 4
Country D 1 3 2 4
Total 18
Incorporating this data into the Spearman formula, we arrive at:
1
2
18
6
4( 4 1)
(
| |
( |
|
(
\ .

= 0.8
The Spearman rank correlation tells us that the country performance rankings from
one period to the next are strongly negatively related. Last periods underperformers
tend to be next periods outperformers, and vice versa.
4.1 Benefits of non-parametric correlation
Non-parametric correlation is particularly suited to financial data because it is much more robust
than the normal Pearson correlation. In the same way, the median is more robust than the mean,
and the mean absolute deviation (MAD) is more robust than the standard deviation. This is due to
the large number of outliers in financial data and, statistically speaking, the small number of data
points normally available.
When outliers or deviations from normality are not present in a data set, rank correlation
essentially results in the same values as a standard Pearson correlation. The rank correlation
equivalent of Table 6, where everything is normally distributed, would look the same with very
similar values.
3.25
The benefit of rank correlation when the underlying distributions have outliers can be
demonstrated by simulating this effect and producing a table of spurious correlations, analogous
to Table 6, for Pearson and Spearman correlations.
Example: Probabilities of spurious correlations
The values in Table 12 and Table 13 were compiled using a Monte Carlo simulation,
in which it was assumed that 5% of the values were outliers.
Pearson correlations
Table 12 shows probabilities of squared Pearson correlations being spurious
(i.e. higher than 0% when in fact they should be 0%).
Table 12 Probabilities* of Pearson correlations being spurious
Probability of non-zero Pearson correl()
2
with 5% of data outliers
1Y 2Y 3Y 4Y 5Y 6Y
Correl()
2
=
0% 18.0% 22.0% 11.0% 7.0% 4.5% 3.5%
10% 13.0% 16.5% 16.5% 14.5% 17.5% 13.0%
20% 6.0% 16.0% 18.5% 22.0% 21.5% 24.5%
30% 9.0% 8.5% 17.0% 24.0% 26.0% 25.0%
40% 8.0% 9.0% 14.5% 14.0% 19.5% 22.0%
50% 13.5% 8.5% 12.0% 11.0% 8.5% 9.5%
60% 10.0% 12.5% 6.0% 6.0% 2.5% 1.5%
70% 13.5% 6.0% 4.5% 1.5% 0.0% 1.0%
80% 6.0% 1.0% 0.0% 0.0% 0.0% 0.0%
90% 3.0% 0.0% 0.0% 0.0% 0.0% 0.0%
100% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%
See the Probabilities Pearson tab in the Excel spreadsheet.
Spearman rank correlations
Table 13 shows probabilities of the squared Spearman rank correlations being
spurious.
3.26
Table 13 Probabilities* of Spearman rank correlations being spurious
Probability of non-zero Spearman correl( )
2
with 5% of data outliers
1Y 2Y 3Y 4Y 5Y 6Y
Correl( )
2
=
0% 48.5% 73.5% 68.0% 78.0% 74.5% 75.5%
10% 26.5% 19.0% 25.0% 19.5% 22.0% 23.5%
20% 13.0% 5.0% 6.0% 2.0% 3.0% 1.0%
30% 5.0% 2.0% 0.5% 0.5% 0.5% 0.0%
40% 5.0% 0.5% 0.5% 0.0% 0.0% 0.0%
50% 2.0% 0.0% 0.0% 0.0% 0.0% 0.0%
60% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%
70% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%
80% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%
90% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%
100% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%
See the Probabilities Pearson tab in the Excel spreadsheet.
Discuss this: Effect of outliers in raw data
Looking at the example above, the Spearman rank correlations in Table 10 (with 5%
of data being outliers) are very similar to the Pearson correlation values in Table 6
(without outliers). However, the Pearson correlation values in Table 6 (without outliers)
and the Pearson correlations in Table 9 (with 5% of data being outliers) look quite
different. Is something different happening when outliers are present?
Secondly, and perhaps unexpectedly, the incidence of spurious Pearson correlations
up to 50% is significantly lower than the same values without outliers or the
Spearman rank correlation with outliers. Why do you think this is happening?
called DT: Effect of outliers in raw data and participate in the discussion online.
Apply your knowledge 5: Spearman rank correlation coefficients
Using the information from Table 3, calculate the Spearman rank correlation
coefficients among stock returns from January 2006 to December 2007.
Discuss this: Comparing Spearman and Pearson correlations
If outliers are an important feature of financial markets, why would you use Spearman
rank correlations (which downplay them) rather than Pearson correlations? Can you
think of financial market applications where the benefit of robustness of Spearman
rank correlations offsets the loss of relevant information that it entails? When would
you ignore the magnitude of outliers? When would this be a mistake?
called DT: Comparing Spearman and Pearson correlations and participate in the
discussion online.
3.27
Perhaps most importantly with outliers, the occurrence of very high Pearson correlations does not
tend to zero at all with one year of monthly data, and tends to zero much less quickly with more
data compared to the other tables. This means that outliers can produce very high spurious
Pearson correlation numbers. It is also possible to construct examples where non-parametric
correlations are present but Pearson correlations are very small. However, these artificial
examples rarely occur with real data.
The Spearman rank correlation is effective when outliers are present as it ignores their
magnitudes. Conversely, the Pearson measure cannot cope with large values that cause
incorrect estimation of covariance and standard deviations.
In Required reading 2 below, Spearman rank correlation coefficients are used to measure
whether individual portfolio return rankings in one market cycle are related to their return rankings
in the next cycle. While this reading is relevant to this topic and largely self-explanatory, it does
not contains some concepts which are not dealt with until later in this subject. While the article
can be understood without reading later topics, some students may wish to read:
the chi-squared test in Topic 5
the capital asset pricing model (CAPM) in Topic 6
how Treynor and Sharpe ratios measure performance in Topic 8.
Required reading 2
Bauman, WS & Miller, RE 1994, Can managed portfolio performance be predicted?,
The Journal of Portfolio Management, vol. 20, no. 4, pp. 3140.
Discuss this: Predicting managed portfolio performance
Consider the use of Spearman rank correlation coefficients in Required reading 2
and determine if a statistically significant relationship exists.
called DT: Predicting managed portfolio performance and participate in the
discussion online.
4.2 Spearman rank correlation matrix
Key concept: Spearman rank correlation matrix
The Spearman rank correlation matrix is a table providing the correlations across
multiple pairings of variables.
For instance, assume the previous example from is extended to include the period 19701979.
Consider the following Spearman rank correlation matrix:
19701979 19801989 19901999
19701979 1.0 0.20 0.40
19801989 1.0 0.80
19901999 1.0
The rank correlation matrix indicates that the correlation of the country rankings was quite low
between 19701979 and 19801989 (rank correlation = 0.20). Therefore, the relationship
between the country rankings between the decades of the 1970s and 1980s is almost
nonexistent. The correlation between the country rankings in the 1970s with the 1990s equals
0.40, indicating a slightly stronger, yet still a weak relationship.
3.28
4.3 Portfolio risk and diversification
The variance of return for a 2-asset portfolio equals:
2
p
=
2 2 2 2
1 1 2 2 1 2 1,2
2 w w w w + +
where:
w
1
= percentage of the portfolio allocated to Asset 1
w
2
= percentage of the portfolio allocated to Asset 2
2
1
= variance of returns for Asset 1
2
2
= variance of returns for Asset 2
1,2
= covariance of returns for assets 1 and 2.
Also, recall that the covariance equals the product of the correlation and the two asset standard
deviations: r
12
2
. So, the portfolio variance can be written:
2 2 2 2 2
1 1 2 2 1 2 1,2 1 2
2
p
w w w w r = + +
Note that if the correlation equals zero, the portfolio variance equals:
2 2 2 2 2
1 1 2 2 p
w w = +
If the correlation equals +1, the portfolio variance equals:
2 2 2 2 2
1 1 2 2 1 2 1 2
2
p
w w w w = + +
in which case, the portfolio standard deviation equals the weighted average of the two asset
standard deviations:
p
= w
1
p
+ w
2
p

And, if the correlation equal 1, the portfolio variance equals:
2 2 2 2 2
1 1 2 2 1 2 1 2
2
p
w w w w = +
in which case, the portfolio standard deviation equals the weighted difference of the two asset
standard deviations:
p
= w
1
1
+ w
2
2

4.4 The geometry of risk
Geometry can be used to illustrate the effects of correlation and hedging on portfolio risk.
We discuss three scenarios below: correlation = +1, 1, and 0.
Correlation equal to +1
Suppose we leverage the original portfolio. The original portfolio return, R
p
, is perfectly positively
correlated (correlation equals +1) with the leverage overlay. The standard deviation on the new
portfolio, L, equals:
L
=
P
+ w
0
p
= (1 + w
0
)
p

where w
o
is the overlay leveraged percentage.
3.29
For example, consider a 25% leverage overlay to a portfolio that has a 10% standard deviation.
Clearly, the overlay (25% invested in Portfolio P) is perfectly positively correlated with Portfolio P.
The standard deviation for the new portfolio, L, is simply:
L
=
P
+ 0.25
p
= 1.25(10%) = 12.5%
Geometrically, the portfolio risk can be represented as a vector with length equal to the portfolio
standard deviation. The vector that represents the risk of this investment has been extended to the
right (zero degree angle with the original portfolio) from 10% to 12.5% as illustrated in Figure 5.
Figure 5 The geometry of risk for a leverage overlay strategy
original portfolio
leverage overlay
12.5%
10%

Correlation equal to 1
Suppose we hedge the original portfolio. The original portfolio return, R
p
, is perfectly negatively
correlated (correlation equals 1) with the hedge overlay. The standard deviation on the new
portfolio, H, equals:
H
=
p
w
o
p
= (1 w
o
)
p

where w
o
is the overlay hedge percentage
For example, consider a 25% hedge overlay to a portfolio that has a 10% standard deviation.
The standard deviation for the new portfolio is simply:
H
=
p
0.25
p
= 0.75(10%) = 7.5%
Think of the strategy as taking a short futures position where the underlying asset is our original
portfolio and the notional principal is equal to 25% of the original portfolio asset value. A short
position and a long position on the same portfolio should have a perfect negative correlation.
The vector that represents the risk of the new investment shrinks to the left (180 degree angle
with the original portfolio) from 10% to 7.5% as illustrated in Figure 6.
Figure 6 The geometry of risk for a hedge overlay strategy
original portfolio
hedge overlay
7.5%
10%

Notice how the geometry is shaped by the correlation. A leverage overlay is perfectly positively
correlated with the original portfolio, causing the new and old portfolio to lie at a zero degree
angle to each other. In contrast, a hedge overlay is perfectly negatively correlated with the
original portfolio, causing the new and old portfolio to lie at a 180 degree angle to each other.
3.30
Correlation equal to 0
If the correlation between the original portfolio and the overlay portfolio equals zero, the two
portfolio (risk) lines will lie at a right angle, and the standard deviation for the new portfolio will
lie along the hypotenuse of the triangle (the side opposite of the right angle). As shown in the
warm-up, the standard deviation for an investment of uncorrelated assets takes the form of
2 2
A B + (i.e.
2 2 2 2
1 1 2 2 P
W W = + ), which also equals the length of the hypotenuse of the
triangle.
For example, if we take the original portfolio with standard deviation of 10% and add a 100%
overlay in an uncorrelated portfolio with standard deviation of 8% (i.e. a futures contract with
notional principal equal to the value of the original portfolio), the total portfolio standard deviation
is equal to:
2 2 2 2
1 0.1 1 0.08 12.8%
P
= + =
Figure 7 The geometry of risk for an uncorrelated overlay
12.8%
8%
Overlay portfolio
Original portfolio
Total portfolio
10%

5 Issues in correlation analysis
The correlation estimate measures the strength of the linear relationship between two variables,
but it does not necessarily imply a causal relationship between the two variables.
5.1 Correlation not causation
A causal relationship is one in which one variable influences the other variable. For instance,
we might observe that sales of sunglasses and number of shark attacks are highly correlated.
But, we would not conclude that sales of sunglasses cause shark attacks.
5.2 Co-occurrence
Instead, the data suffer from co-occurrence (i.e. both variables shift at the same time).
The correlation is high because sunglass sales rise during the summer, coinciding with larger
numbers of people swimming in the ocean, making shark attacks a greater possibility.
3.31
5.3 Correlation only measures linear relationships
As illustrated in Figures 2 and 3, correlation measures the direction and strength of the linear
relationship between two variables. If the scatter plot is very tight around an upward sloping line,
the correlation is close to +1 as demonstrated in Figure 2. If the scatter plot is very tight around
a downward sloping line, the correlation is close to 1, as demonstrated in Figure 3. If the scatter
plot follows neither an upward nor a downward slope (e.g. a circular pattern), the correlation will
equal zero (no line could be inserted to represent the scatter plot). See Figure 4.
Correlation is not an appropriate statistic if the relationship between the variables is non-linear.
For example, consider the following data for Y and X:
Y X
1 1
4 2
4 2
1 1
The correlation between Y and X equals zero, which correctly implies there is no linear relationship
between Y and X. But, as shown in Figure 8, Y and X are related: Y = X
2
. Therefore, the correlation
is not a good statistic to use for variables thought to be nonlinearly related.
Figure 8 Non-linear relationship
3.00 2.00 1.00 0.00 1.00 2.00 3.00
5.00
4.00
2.00
1.00
3.00
Y
X

5.4 Two viewpoints of data
When looking at data there are two viewpoints to consider:
a priori or ex-ante (before events) forecasting view
a posteriori or ex- post (after events) historical view.
The distinction between these two viewpoints helps illustrate the difference between correlation
and causation.
The a priori approach emphasises the causal aspect of relationships.
3.32
Example: A priori approach
The return series on physical gold and the return series on the company Newcrest
Mining Ltd (NCM) may be correlated because rises and falls in the gold price cause
NCM shares to become more or less valuable. This is the a priori approach.
It emphasises the causal aspect of relationships. Even if the calculation of correlation
coefficients showed only a slight or intermittent correlation between the variables,
it is quite likely that the belief that a rising gold price causes NCM shares to be a
more valuable security would be retained.
Figure 9 Newcrest Mining share prices versus gold prices
NCM share price vs gold price
0
5
10
15
20
25
30
35
40
A
u
g
-
8
7
A
u
g
-
8
8
A
u
g
-
8
9
A
u
g
-
9
0
A
u
g
-
9
1
A
u
g
-
9
2
A
u
g
-
9
3
A
u
g
-
9
4
A
u
g
-
9
5
A
u
g
-
9
6
A
u
g
-
9
7
A
u
g
-
9
8
A
u
g
-
9
9
A
u
g
-
0
0
A
u
g
-
0
1
A
u
g
-
0
2
A
u
g
-
0
3
A
u
g
-
0
4
A
u
g
-
0
5
A
u
g
-
0
6
A
u
g
-
0
7
A
u
g
-
0
8
A
u
s

$
p
e
r
s
h
a
r
e
0
200
400
600
800
1000
1200
U
S
D
p
e
r
o
z
NCM (LS) Gold (RS)

A posteriori approach
A quantitative analyst could collect return series for many stocks and for many
different commodities, and calculate the pair-wise correlations for all the stocks and
commodities. Even with no opinions about which changes might be causing which
results, information about correlations might lead the analyst to make discoveries
about causal relationships which might not have been otherwise thought of.
5.5 Why do data series display correlation?
When two series of data exhibit a high degree of correlation, there may be a number of reasons
underlying that result. Some of these reasons are:
coincidence or chance
spurious correlation
ceteris paribus
common cause
causation and causality.
3.33
Coincidence or chance
Even a relationship that is statistically significant at the 95% level has a 5% chance that it may
be the outcome of a coincidence.
Of particular relevance in this regard is the ex post (after events) trap or seeing
is believing. That is, just because an event occurs that had a very small chance of occurring
ex ante (before events) does not mean that it must have been originally set in motion by design.
A link between the events should not be immediately established without further proof.
Example: Ex post trap Malkiels coin tossing investment managers
The following coin tossing scenario highlights the potential a posteriori trap:
The contest begins, and 1000 contestants flip coins. Just as would be expected by
chance, 500 of them flip heads, and the winners are allowed to advance to the
second stage of the contest and flip again. As might be expected, 250 flip heads.
Operating under the laws of chance, there will be 125 winners in the third round,
63 in the fourth, 31 in the fifth, 16 in the sixth and eight in the seventh.
By this time, crowds start to gather to witness the surprising ability of these expert
coin tossers. The winners are overwhelmed with adulation. They are celebrated as
experts in the art of coin-tossing their biographies are written and people urgently
seek their advice. After all, there were 1000 contestants, and only eight could
consistently flip heads.
(Malkiel 2007)
Spurious correlation
Key concept: Spurious relationship
A spurious relationship refers to an invalid inference drawn from an observed
correlation. It is a special case of coincidence. In particular, a spurious relationship
often arises from highly correlated (either positive or negative) variables that have no
logical connection.
Example: Sharks and sunglasses
A researcher might observe the simultaneous increase in shark attacks and sales of
sunglasses and assume one is causing the other. The researcher in this experiment,
of course, ignores the missing variables that were actually causing both (sun and high
temperatures).
Example: Population increase and earth rotation slowing
As the population of the earth has steadily increased by approximately seven billion
over the past five million years, the length of the day has steadily increased by a
minute and a half. With all those data points, these increasing relationships should
be highly statistically significant.
The reality is, however, that humanity is just going about its business and,
unrelatedly, the Earths rotation is slowing down.
3.34
Ceteris paribus
Key concept: Ceteris paribus
Ceteris paribus is a Latin phrase meaning all other things being equal. In analysis it
refers to attempting to isolate particular (causal) factors from a range of other
potential environmental variables. This phrase is more often used in social science
than in physical science because no controlled experiments would be possible in the
former. In order to predict the most likely outcome of certain action in social science,
one assumes that one can control the action/reaction of other factors as if one were
conducting a controlled experiment.
Ceteris paribus besets correlation and causal issues. In financial markets, and the real world
generally, there are so many things happening all the time that it can be hard to sort out the key
drivers from all the other things, some of which may be peripheral noise.
Discuss this: Statistical significance
You buy stocks with positive earnings revision, low PEs and the company has a chief
executive officer with a Harvard business degree. You discover that this mixture
correlates well with outperformance. How can you determine which, if any, of the
characteristics described above contributed to the outperformance?
called DT: Statistical significance and participate in the discussion online.
Common cause
Strength in the economy over a period may cause the sharemarket to rise and bond prices to fall.
In these circumstances, a negative correlation could be measured between share prices and bond
prices. It would be erroneous to conclude, however, that the strength in the sharemarket caused
the weakness in the bond market because both are the results of a growing economy.
Determining causality
There is a possibility that the variation in series A causes the variation in series B, B causes A or
that they may be co-determined. However, causation or theoretic linkage is only one of a large
number of possible explanations as to why any two particular series are correlated.
A quantitative analyst can do the following things to ensure that reliable causal relationships are
being uncovered:
Collect as much data as possible and make every effort to minimise the risk of Type I and
Type II errors.
Ensure that the theoretical foundations are sound.
Watch out for errors.
Trace out intermediate steps in a chain of reasoning and rethink what looks like a spurious
correlation if there is a lot of data that can fill in intermediate steps in a theory.
3.35
Example: Plausibility of causation
Angry Spanish bulls and red flags
There is a very high correlation between bulls in Spain having red capes waved at
them and the bulls getting irritated. Do bulls hate red? This hypothesis falls over if
it turns out that bulls are colour-blind animals.
Sunspot cycle and cycle of wheat prices
Why is the sunspot cycle highly correlated with the cycle of wheat prices trading in
Chicago? Is this another coincidence, like the population of the earth growing in line
with the length of the day?
The causal explanation is more likely to be accepted when it is discovered that the
sunspot cycle can vary between eight and 18 years, sunspot and wheat price data
have been collected over a long time, and that a key intermediate variable, climate,
can be shown to be related both to wheat prices and to the suns activity.
5.6 Granger causality
Key concept: Granger causality test
The Granger causality test is a hypothesis test, based on regression, to determine if
one time series of data can provide statistically significant useful information about a
series of data later in time establishing that one event causes another. To be reliable,
the time series data used in the regression must be made stationary by differencing
(i.e. taking period-to-period change of a time series). If the lagged values of a
stationary time series (X) is a significant explanatory factor in the regression model
of the current values of another stationary time series (Y), then X is said to
Granger-cause Y. Conversely, if the lagged values of (Y) is a significant explanatory
factor in the regression model of the current values of (X), then Y is also said to
Granger-cause X. The story would be more convincing if one time series
Granger-causes the other time series but not the other way around.
This approach relies on the hypotheses that:
time only travels forwards
that an event cannot be caused by another event that has not happened yet.
While these hypotheses appear very reasonable, it is possible that there is no causal relationship
between the first two factors and that a third factor that is causing the first two factors. It is also
very possible that although a time series of data always precedes another, it is not a causal
relationship. Consider the fact that from 1 to 24 December each year, we have a large and very
reliable set of data that people send each other Christmas cards either electronically or in paper.
Subsequently, each year, Christmas occurs on 25 December. A Granger causality analysis could
lead to the false conclusion that Christmas cards cause Christmas. Therefore, this purely
quantitatively technique has its limitations and is not a substitute for a complete understanding
of the true causes and effects of different outcomes.
3.36
Further resources
Brainard, WC & Tobin, J 1968, Pitfalls in financial model building,
American Economic Association, vol. 58, no. 2, pp. 99122,
viewed 19 March 2012, EBSCO Business Source Corporate database.
Smith, G 1975, Pitfalls in financial model building: A xlarification,
American Economic Review, June, vol. 65, issue 3, pp. 510516,
viewed 19 March 2012, EBSCO Business Source Corporate database.
These resources provide a good discussion of the pitfalls in the area of causality.
5.7 The outlier problem in correlation
Key concept: Outlier
An outlier is an extreme or abnormal observation that is not representative of the
majority of observations in the sample.
As shown by the graphs contained in Figure 10, outliers can distort correlation. In a highly
correlated series of data, one large outlier may bias the correlation measure downward, incorrectly
implying a lack of relationship. Likewise, in an uncorrelated series of data, one large outlier may
bias the correlation measure upward, incorrectly implying a strong relationship. The problem is
especially acute for small funds. Because of the high leverage of the funds and short history,
even reasonable changes in market value cause abnormally large rates of return relative to the
remaining sampled observations.
Figure 10 Outliers and correlation
Outlier biasing correlation downward
Outlier biasing correlation upward
5 4 3 2 1 2
6 4 2 2 4 6
Y
Y
1.5
2.5
2
X
1
1.5
6
5
4
3
2
1
2
3
4
5
X

3.37
A suggested solution to the outlier problem follows two steps:
Identify the outlier(s). Examine the extent to which each observation contributes to the
correlation. Outliers can be easily identified as those that make an unusual or abnormal
contribution to the correlation.
Use robust estimation methods to derive the correlation. These methods diminish the weight
or the importance of the outlier in the correlation calculation.
5.8 Partial correlation
As we already know, the correlation statistic measures the strength of the (linear) relationship
between two variables. For example, we might wish to measure the correlation between industry
sales and GDP. But, perhaps the relationship between industry sales and GDP depends on other
factors (e.g., whether the interest rates are high or low, the nation is at war or peace, or whether
consumer sentiment is soaring or plunging). Therefore, ignoring these other factors, computing the
correlation simply between industry sales and GDP, we might derive a misleading conclusion.
Key concept: Partial correlation
Partial correlation is the correlation between two variables after controlling or
removing the effects of other related variables.
Example: Partial correlation
The partial correlation between industry sales and the GDP equals the correlation
between industry sales and GDP, holding all other variables constant (e.g. assuming
no changes in interest rates, inflation, consumer sentiment, or any other variable that
is related to industry sales). Therefore, the partial correlation measures the
relationship that isolates sales and GDP.
6 Statistical significance
Rarely is a researcher able to observe an entire population of observations. If the entire
population could be observed, the researcher could merely compute the population mean and
standard deviation directly. Instead, researchers usually observe samples taken from the
population and then must calculate estimates from the sample (subsets of the population) from
which to draw inferences about the unknown population parameters.
6.1 Sampling error
Key concept: sampling error
Sampling error refers to the difference between a sample statistic and the
corresponding population parameter that it is trying to estimate.
Sampling error is caused by sampling from the population, rather than using the entire population
to derive conclusions. Fortunately, sampling error declines as the sample size grows.
Example: Sampling error
If the population mean is 100 and the sample mean is 101, the sampling error for
the sample mean is 1 (101 100).
3.38
6.2 Confidence intervals and limits
A point estimate is a single number that is used to estimate a population parameter. For example,
the sample mean is a point estimate of the population mean.
Key concept: Confidence interval
A confidence interval is an estimated range within which the population parameter is
likely to be contained.
For instance, a researcher might want to derive the 95% confidence interval for the population
mean. This implies that in repeated sampling, 95% of such confidence intervals will include the
true (unknown) population mean.
Key concept: Confidence limits
Confidence limits refer to the lower and upper bounds of the confidence level.
For example, the 95% confidence level for industry sales might equal $100 million up to and
including $120 million. Both $100 million and $120 million are included in the interval
(i.e. the interval includes the two limits). The lower confidence limit is $100 million and the
upper confidence limit is $120 million.
6.3 Statistical significance
Key concept: Statistical significance
Statistical significance refers to the probability that a relationship observed in a
sample did not happen by chance.
Therefore, if we conclude that an estimate is statistically significant, we are saying that the
number we observed is unlikely to be attributable to chance. In other words, we can rely on the
estimate.
6.4 Correlation confidence intervals
The confidence interval for a correlation coefficient is derived in three steps:
Step 1: Convert the correlation coefficient, r, to a normally distributed random variable:

1 1
1
2 1
r
Z n
r
+ | |
=
|
\ .

Step 2: Derive the confidence interval for Z. For example, the 95% confidence interval for a
normally distributed random variable, Z, equals [Z 1.96
Z
, Z + 1.96
Z
], where
1 3
Z
N = and N is the number of paired observations used to derive the correlation
estimate.
Step 3: Convert the confidence limits for Z to confidence limits for r using the following formula:

2
2
1
1
Z
Z
e
r
e
=
+

3.39
Example: Confidence interval for a correlation estimate
Calculate the 95% confidence interval for a correlation estimate of 0.50 derived from
a sample of 103 observations.
Answer:
First we convert the correlation to a normally distributed variable:
Z = ( ) ( )
1 1
1.50 / 0.50 3 0.5493
2 2
In In = =
Next, we derive the confidence interval for Z: 1 3
Z
N = = 1/10 = 0.10
95% confidence interval lower limit: 1.96
Z
Z = 0.5493 1.96(0.10) = 0.3533
95% confidence interval upper limit: 1.96
Z
Z + = 0.5493 1.96(0.10) = 0.7453
Convert confidence limits for Z to confidence limits for r:
2
2
1
1
Z
Z
e
r
e
=
+

95% confidence interval lower limit if Z = 0.3533:
( )
( )
2 0.3533
2 0.3533
1
1
e
r
e
=
+
= 0.3393
95% confidence interval upper limit if Z = 0.7453:
( )
( )
2 0.7453
2 0.7453
1
1
e
r
e
=
+
= 0.6323
Therefore, the 95% confidence interval for r equals [0.3393, 0.6323].
6.5 Statistically significant correlation estimate
Key concept: Statistically significant correlation estimate
A statistically significant correlation estimate is one where its estimated confidence
interval does not include the value of zero.
Consider the confidence interval [0.20, 0.30], which includes zero. In this case, we cannot
reject the hypothesis that the (population) correlation parameter equals zero. Stated differently,
we would conclude that the correlation estimate is not statistically significant (the estimated value
is not significantly different from zero). If the correlation estimate is not statistically significant,
then we cannot reject the hypothesis that there is no (linear) relationship between the two
variables.
Conversely, if the estimated confidence interval does not include zero (e.g. [0.34, 0.63]), we can
reliably reject the hypothesis that the population correlation equals zero. We would conclude that
the correlation estimate is statistically significant (i.e. the estimated value is significantly different
from zero). If the correlation estimate is statistically significant, then we can reject the hypothesis
that there is no (linear) relationship between the two variables.
3.40
6.6 The problem of heteroscedasticity
Heteroscedasticity refers to a data series or scatter plot characterised by a non-constant
dispersion or variance. An illustration is provided in the following graph.
Figure 11 Heteroscedasticity
Y
x

As illustrated in Figure 11, the scatter plot becomes more dispersed (larger variance) as the
returns on Portfolio X grow large. Some studies indicate that heteroscedasticity causes the
correlation estimate to be biased downward, leading to an erroneous conclusion about
diversification potential of heteroscedastic portfolios. Therefore, special care should be taken
when inferring diversification potential from the correlation estimate from heteroscedastic return
series.
Review your progress 1
Use the following data to answer Question 1.
Observation Return for Portfolio X Return for Portfolio Y
1 0.10 0.20
2 0 0
3 0.10 0.20
1. Assuming the co-variance for portfolios X and Y equals 0.02, the correlation
between Portfolio X and Y returns equals:
A 1.00
B 0.00
C 0.50
D 1.00
2. Thomas Smith is a pension sponsor who makes asset allocation recommendations
for his clients. The pension of Software, Inc., asks Smith to select two hedge
funds out of a list of four to include in the pension. All four hedge funds have
identical return distribution characteristics, except for correlations with each other.
The pensions main objective is to identify two hedge funds that offer the
combined lowest risk. Smith derives the following correlation matrix among the
returns for the four hedge funds:

1 0.80 0.20 0.25
1 0.90 0.23
1 0.30
1
(
(
(
(

3.41
The best combination of hedge funds is:
A Hedge Fund 2 and Hedge Fund 3
B Hedge Fund 2 and Hedge Fund 4
C Hedge Fund 3 and Hedge Fund 4
D Hedge Fund 1 with Hedge Fund 3
3. The lower and upper limits of the covariance are:
Lower limit Upper limit
A +
B 0 +
C 0 +1
D 1 +1
4. The lower and upper limits of the correlation are:
Lower limit Upper limit
A +
B 0 +
C 0 +1
D 1 +1
5. The variance-covariance matrix of annual returns between funds 1, 2, and 3 is:
variance-covariance matrix =
0.04 0.06 0.08
0.09 0.10
0.16
(
(
(
(
(

From the data provided, the correlation between funds 2 and 3 equals:
A 0.10
B 0.50
C 0.83
D 1.00
6. The main advantage of the Spearman rank correlation is that it:
A does not require that the data follow a normal distribution
B measures the correlation for nonlinear relationships
C controls for heteroscedasticity
D controls for spurious correlations
7. Annual returns for four consecutive years for funds X and Y are provided below:
Observation Fund X Fund Y
1 0.10 0.05
2 0.20 0.00
3 0.30 0.75
4 0.40 0.20
The Spearman rank correlation for the fund X and Y rates of return equals:
A 0.50
B 0.45
C 0.60
D 0.75
3.42
8. Stanley Quale makes asset allocation recommendations for a globally
diversified fund. Quale derives the rank correlations of returns for
various country indices for three decades with the following results:
19701979 19801989 19901999
19701979 1.00 0.75 0.40
19801989 1.00 0.80
19901999 1.00
From the data above, Quale should conclude that country rankings tend to:
A persist between consecutive decades
B be strongly positively related over time
C reverse between consecutive decades
D to be uncorrelated over time
9. The correlation of any variable with itself must equal:
A 1
B zero
C 1
D infinity
10. Theresa Haight, portfolio manager with Risk Attributes, Inc., is instructed to
examine the standard deviation of a portfolio that combines two uncorrelated
funds. The individual funds have identical standard deviations. Haight can
measure the risk of the combined portfolio along:
A a vector that has a 0 degree angle with the original portfolio.
B a vector that has a 180 degree angle with the original portfolio.
C a vector that has a 60 degree angle with the original portfolio.
D the hypotenuse of a right triangle.
11. Outliers cause the Pearson product-moment correlation to move toward:
A 1.00
B 0.00
C 0.50
D 1.00
12. William Moore, analyst with Performance Stats, Inc., notices that the returns
on Fund X are exactly equal to the square of the returns on Fund Y. The
relationship holds consistently throughout the sample period. Moore will
find that the correlation between the Fund X and Fund Y returns equals:
A 1.00
B 0.00
C 0.50
D 1.00
13. A spurious relationship is most likely to arise in a scatter plot exhibiting:
A zero correlation
B significant outliers
C very high negative correlation
D a strong logical connection
3.43
14. Which statistic measures the relationship between two variables after
controlling for the effects of additional variables?
A Partial correlation
B Spearman rank correlation
C Pearson product-moment correlation
D Wilcoxon correlation
15. Woodrow Burkski and Elenora Ekstrov recently sampled returns for various
hedge overlay strategies. Burkski states that samples with large sampling error
are less likely to provide statistically significant estimates. Ekstrov contends
that large sampling error causes estimated confidence intervals to increase.
Regarding the statements of Burkski and Ekstrov:
Burkski Ekstrov
A Correct Correct
B Correct Incorrect
C Incorrect Correct
D Incorrect Incorrect
16. Investment Partners, Inc., recently examined the relationship between the
returns earned on their hedge fund and on their clients pension fund.
Using monthly observations over the past six years, the correlation estimate
equals 0.30. Their client asks for the highest value that the correlation might
reach, using a 95% level of confidence. Investment Partners should advise their
client that the correlation between the hedge fund and the pension fund might
reach as high as:
A 0.07
B 0.50
C 0.55
D 0.95
17. Four 95% confidence intervals for the correlation are provided below.
The confidence interval that indicates that the correlation estimate is
statistically significant is:
A [0.20, 0.30]
B [0, 0.90]
C [0.75, 0]
D [0.10, 0.20]
18. Thomas Wilson, analyst at Macro Associates, Inc., examines the relationship
between company sales and firm size measured as the stock price times
shares outstanding. Wilson notices that company sales are much more volatile
for large companies than for small companies. The data examined by Wilson is
characterised by:
A serial correlation
B rank correlation
C spurious correlation
D heteroscedasticity
3.44
19. Match the concepts to the definitions in the table below.
Key concept Definition
statistically significant
correlation estimate
replaces the values of each random variable with their rank among all
other values from the same sample
Spearman rank correlation an extreme or abnormal observation that is not representative of the
majority of observations in the sample
covariance an estimated range within which the population parameter is likely to
be contained
outlier the correlation between two variables after controlling or removing the
effects of other related variables
volatility does not include the value of zero
partial correlation the variation of a variable over a specific time period
confidence interval a statistic used to measure the relationship between two variables
References
Malkiel, B 2007, A random walk down Wall Street: The time tested strategy for successful investing,
9th edn, WW Norton & Company, New York.
Suggested answers
Note: In the interests of providing students with maximum opportunity for hands-on learning,
some solutions provided are partial only.
Apply your knowledge 1: Calculating variance and correlation of stock returns
See the AYK 1 tab in the Excel spreadsheet.
Apply your knowledge 2: Correlations for two subsamples
Apply your knowledge 3: Spurious correlation coefficients
Apply your knowledge 4: Calculation of portfolio variance using portfolio
weightings
Apply your knowledge 5: Spearman rank correlation coefficients
3.45
Review your progress 1
1. D The formula for the correlation is: rX,Y =
X,Y
X Y

where
X,y
is the covariance between X and Y, and
X
and
y
are the standard deviations of
X and Y, respectively:
standard deviation for X:
X
=
2
( )
1
i
X X
n

standard deviation for Y:
y
=
2
( )
1
i
Y Y
n

Given that the covariance equals 0.02, the standard deviations equal:

2 2 2
( 0.10 0) ( 0 0) ( 0.10 0)
2
X
+ +
= = 0.10

2 2 2
( 0.20 0) ( 0 0) ( 0.20 0)
2
Y
+ +
= = 0.20
Therefore, the correlation equals
0.02
0.10 0.20
= 1. The correlation in this problem can be
determined quickly and simply by noticing that R
Y
= 2R
X
, which indicates a perfectly positive
linear relationship.
2. C The correlation matrix reports the correlations for each pair of funds. The correlation for
hedge funds i and j is reported at the intersection of row i and column j. The best
diversification potential is offered by the pair of funds with the correlation that is farthest from
+1, which, in this example, is the combination of hedge funds 3 and 4 (correlation = 0.30).
3. A The covariance is unbounded in either direction. Therefore, the lower and upper limits of the
covariance are and +, respectively.
4. D The correlation is a scaled transformation of the covariance (correlation equals covariance
divided by the product of the standard deviations). The scaling causes the correlation to be
bounded by 1 and +1, respectively.
5. C The variance-covariance matrix reports variances down the diagonal and covariances off the
diagonal. The correlation between funds 2 and 3 equals:
2,3
2 3
2,3
r

=
The covariance between funds 2 and 3 equals 0.10 as reported in Row 2, Column 3.
To derive standard deviations, we must take the square root of the variances. For example,
the standard deviations
for Fund 2 = 0.09 = 0.30.
for Fund 3 = 0.16 = 0.40.
Therefore, the correlation between funds 2 and 3 equals:
2,3
2,3
2 3
0.10
0.30 0.40
r

= =

= 0.83.
6. A The Pearson correlation assumes the data follow a normal distribution, and is highly
sensitive to outliers. In contrast, the Spearman rank correlation is a non-parametric
statistic that does not require that the data follow a normal distribution.
3.46
7. C The Spearman rank correlation equals the Pearson correlation after converting the
original data series to ranks:
Observation Fund X Fund Y
1 1 2
2 2 1
3 3 4
4 4 3
The Spearman rank correlation can be calculated by using the following formula:

2
2
1 6
( 1)
i
d
N N
(
| |
( |
|
(
\ .

= 1 [6(1 + 1 + 1 + 1) / 60] = 0.60
8. C The rank correlations between consecutive decades (19701979 versus 19801989
and 19801989 versus 19901999) equal 0.75 and 0.80, respectively. Both
correlations are large and negative, indicating a strong negative relationship in rankings
between consecutive decades. Therefore, the data indicate that rankings tend to reverse
between consecutive decades (top performers in one decade become poor performers in
the subsequent decade, and vice versa).
9. C The correlation of any variable with itself must equal 1.
10. D If the correlation between two funds equals zero, the two fund (risk) lines will lie at right
angles, and the standard deviation for the new portfolio will lie along the hypotenuse of
the triangle. The standard deviation for an investment of uncorrelated assets takes the
form of
2 2
A +B which also equals the length of the hypotenuse of the right triangle
(i.e. one of the angles in a right triangle has a 90 degree angle).
11. B Outliers are observations that deviate substantially from the rest of the sample, causing
the correlation to move toward zero.
12. B The scatter plot of the returns for funds X and Y will be perfectly U-shaped. The
correlation measures the strength of linear relationship between two variables. If the
scatter plot is U-shaped, no line can be constructed that reliably represents the
relationship between the two return series. Therefore, the correlation equals zero.
13. C A spurious relationship refers to an invalid inference drawn from an observed correlation.
In particular, a spurious relationship often arises from highly correlated (either positive or
negative) variables, but with no logical connection between the variables.
14. A The partial correlation is the correlation between two variables after controlling or
removing the effects of other related variables.
15. A Sampling error refers to the difference between a sample statistic and the corresponding
population parameter that it is trying to estimate, and is caused by sampling from the
population, rather than using the entire population to derive conclusions. Statistical
significance refers to the reliability of sample statistics. Samples with large sampling
error provide estimates with little statistical significance or reliability. Therefore,
Burkski is correct. Confidence intervals provide a range estimate rather than a point
estimate for a population parameter. As sampling error increases, the confidence interval
also increases, indicative of large uncertainty or reliability associated with the sample.
Therefore, Ekstrov is also correct.
3.47
16. B To derive the upper bound, use the following three steps:
Step 1: Convert the correlation, r, to a normally distributed random variable:

1 1 1
l
2 1 2
1.30
l 0.5l (1.86) 0.31
0.70
r
Z
r
+
=
| | | |
= = =
| |
\ . \ .
n n n
Step 2: Derive the confidence interval for Z. For example, the 95% confidence interval for
a normally distributed random variable, Z, equals [Z 1.96sZ, Z + 1.96sZ], where
1 3
Z
N = and N is the number of paired observations (N = 72) used to derive the
correlation estimate: 1 3
Z
N = = 1 / 8.3 = 0.12.
Step 3: Convert the confidence limits for Z to confidence limits for r using the following
formula:
2
2
1
1
Z
Z
e
r
e
=
+

95% confidence interval upper limit: Z + 1.96s
Z
= 0.31 + 1.96(0.12) = 0.545
Convert confidence limits for Z to confidence limits for r:
95% confidence interval upper limit:

2
2
1
1
Z
Z
e
r
e
=
+
for Z = 0.545: upper limit for r: 0.497
Therefore, the upper limit for the correlation is approximately equal to 0.50.
17. D A correlation estimate is statistically significant if its confidence interval does not include
zero. The correlation confidence interval is the range within which the population
correlation is likely to be found. The confidence interval in Choice D does not include
zero, indicating that the correlation likely does not equal zero. Therefore, this indicates
that the correlation estimate is statistically significant.
18. D Heteroscedasticity refers to a data series characterised by a non-constant variance,
which may cause the correlation estimate to be biased downward. In the example,
company sales become much more volatile as company sales increase, indicating that
the variance of company sales is not the same for small and large companies (i.e. the
data are characterised by heteroscedasticity).
19. Key concept Definition

statistically significant
correlation estimate
does not include the value of zero

Spearman rank
correlation
replaces the values of each random variable with their rank among all other values
from the same sample

covariance a statistic used to measure the relationship between two variables

outlier an extreme or abnormal observation that is not representative of the majority of
observations in the sample

volatility the variation of a variable over a specific time period

partial correlation the correlation between two variables after controlling or removing the effects of other
related variables

confidence interval an estimated range within which the population parameter is likely to be contained

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= Column vector of asset returns for N assets.

= Column vector of asset weights for N assets.

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