RiskMetrics - Correlation

Introduction

Identifying Risk

Measuring Risk

Managing Risk

Correlation

Understand the concept of correlation and its effect on portfolio risk.

Correlation measures comovement

Whereas volatility shows how risky individual assets are, correlation measures how closely individual assets are interrelated. Correlation is calculated by observing historical comovement in returns, and measured on a scale between -1 and 1.

The following Flip book simulates the daily price changes of two different stocks. Plotting the price changes for both stocks over time allows you to visualize how returns move relative to each other:

Interpreting correlation

A correlation of 1 means that returns move together perfectly, whereas a correlation of -1 implies perfect opposite movement. A 0 (zero) correlation implies independence. We generally observe positive correlations within an asset class (for example, within equities), and in particular within the same country and industry (e.g., US technology stocks). Note that high correlation between two assets does not imply that they are directly linked to each other. They may just be driven by similar factors, such as interest rates and oil prices.

Correlations affect portfolio risk

Correlations are a key driver of total portfolio risk. Portfolio managers look for assets with low (or even negative) correlations to achieve better diversification. For example, international investments often yield high diversification benefit due to low correlation of currency rates with other assets.

Dynamic correlations

Investors should be aware, however, that correlations are dynamic and often change during turbulent market conditions, which may dramatically impact portfolio risk.