Examples of correlation coefficient in the following topics:
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- A diversified portfolio containing investments with small or negative correlation coefficients will have a lower variance than a single asset portfolio.
- A fundamental justification for asset allocation (or Modern Portfolio Theory) is the notion that different asset classes offer returns that are not perfectly correlated, hence diversification reduces the overall risk in terms of the variability of returns for a given level of expected return.
- Although risk is reduced as long as correlations are not perfect, it is typically forecast (wholly or in part) based on statistical relationships (like correlation and variance) that existed over some past period.
- A diversified portfolio containing investments with small or negative correlation coefficients will have a lower variance than a similar portfolio of one asset type.
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- Recall that Beta is a number describing the correlated volatility of an asset or investment in relation to the volatility of the market as a whole.
- It is able to accomplish this because the correlation coefficient, R, has been removed from Beta.
- Another statistical measure that can be used to assess stand-alone risk is the coefficient of variation.
- It is also known as unitized risk or the variation coefficient.
- A lower coefficient of variation indicates a higher expected return with less risk.
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- An investor can reduce portfolio risk by holding combinations of instruments which are not perfectly positively correlated (correlation coefficient).
- Co-variances can be thought of as correlations.
- If there is zero correlation among all three fruits, we have cut our risk in thirds by owning all three, but if they are perfectly correlated, we haven't diversified away any of our risk.
- In reality, they are probably positively correlated, since they are all fruits, but not at all perfectly.
- The formula shows that the overall variance in a portfolio is the sum of each individual variance along with the cross-asset correlations.
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- A portfolio's Beta is the volatility correlated to an underlying index.
- In this section, we will discuss the idea of calculating a Beta coefficient to help investors measure the risk-reward trade-off for a blended pool of investments.
- A portfolio's Beta is the volatility correlated to an underlying index.
- A Beta of zero in this situation doesn't necessarily mean a risk free asset, it simply means that it is not correlated with the benchmark.
- But let's say you have $300,000 to invest; you could put that in a fund that is indexed to the S&P 500 and is perfectly correlated with it.
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- Price risk is positively correlated to changes in interest rates, while reinvestment risk is inversely correlated.
- To sum up, price risk and interest rates are positively correlated.
- Reinvestment risk and interest rates are inversely correlated.
- The former is positively correlated to interest rates, while reinvestment risk is inversely correlated to fluctuations in interest rates.
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- The beta coefficient, expressed as a covariance, is the risk of a new project in relation to the risk of the market as a whole.
- A company itself will be considered, for investment purposes, as a "portfolio of assets," and its beta coefficient will represent the weighted average of each "asset's" beta.
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- The amount of value added needs to be greater than the firm's investors could have achieved investing in the market portfolio, adjusted for the leverage (beta coefficient) of the firm relative to the market.
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- This premium is sensitized to movements in relevant markets using the beta coefficient.
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- Beta, bs, and bv are coefficients, and alpha is an error term.
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- Diversification relies on the lack of a tight positive relationship among the assets' returns, and works even when correlations are near zero or somewhat positive.
- On the flip-side, hedging is the tactic that relies on negative correlations among assets.