Correlation indicates the extent to which two or more variables move in relation to each other. Correlation helps investors make informed decisions about portfolio diversification.
What does a correlation coefficient of -0.8 indicate?
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Select an option above to see an explanation here.
A) A strong positive correlation would have a coefficient close to 1. B) A strong negative correlation has a coefficient close to -1, so -0.8 indicates a strong negative correlation. C) A weak positive correlation would have a coefficient close to 0. D) No correlation would have a coefficient of 0.
Which of the following is NOT a reason to analyze correlation in finance?
A) Understanding the relationships between different assets is vital to analyzing correlation. B) Making informed decisions about portfolio diversification is another crucial reason to analyze correlation. C) Correlation does not imply causation, so analyzing correlation cannot determine causation between two variables. D) Assessing the risk of a portfolio is another reason to analyze correlation.
In the early 2000s, many investors believed that housing prices and stock market returns were negatively correlated, meaning that the other would decrease when one increased. This belief led to the overinvestment in real estate as a means of diversification. However, during the 2008 financial crisis, housing prices and stock market returns plummeted, proving that the assumed negative correlation was inaccurate.
What is the main difference between correlation and covariance?
A) Both correlation and covariance measure the direction of the relationship between two variables. B) Both correlation and covariance measure the strength of the relationship between two variables. C) Covariance measures the dependency between two variables, while correlation indicates the strength of their relationship. D) Both correlation and covariance can be used for diversification and regression analysis.
An investor is considering adding gold to their portfolio, consisting of stocks and bonds. They analyze the historical returns of gold, stocks, and bonds and find that gold has a low or negative correlation with stocks and bonds. Adding gold to their portfolio could help diversify their investments and reduce overall risk.
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Example Series 65 Example Practice Question
* Interpreting correlation values: Understanding the strength and direction of the relationship between two variables based on the correlation coefficient, which ranges from -1 to 1. * Correlation versus covariance: Correlation is a standardized measure of the relationship between two variables, while covariance is an unstandardized measure that indicates the direction of the relationship.
* Interpreting correlation values: A correlation of 0.8 indicates a strong positive relationship between two variables, while a correlation of -0.5 indicates a moderate negative relationship. * Correlation versus covariance: If the covariance between two variables is 15, it indicates a positive relationship, but the strength of the relationship is unclear. If the correlation is 0.6, it indicates a moderately strong positive relationship.