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Correlation in Finance


What is the concept of correlation?  How is it used in finance?

The concept of correlation is used to sort out the relationship between the two variables or numerical values. It is statistical tool for finding and measuring the linear relationship between two variables such as returns of two securities. The value of correlation could be positive, negative or zero. It always varies between the -1.0 (negative correlation) and +1.0 (positively correlation). It is calculated by using the formulae depict below: 

Correlation A, B = Covariance AB/ Standard deviation A* Standard deviation B 

In finance, it is used as a measure relationship between two securities and their impact on each other. It also helps the investors in taking investment decisions. For example: correlation of the two securities A and B is -0.50, it indicates that there is negative relationship between the two securities. It means that returns are negatively correlated. In order to figure out the return and risk relationship of portfolios of securities, correlation is best method. 

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