meaning and types of correlation: Correlation: What It Means in Finance and the Formula for Calculating It


When the ratio of change between two variables is constant, then the correlation is said to be linear. In linear correlation, the change in one variable is in a constant proportion to the other variable. Correlation between two variables is said to be positive when both the variables move in the same direction.

The deviations x and y when taken from actual means are usually decimals and the multiplication and squaring of these values is often a tedious task. The student should note that our ratio or coefficient is simply the average product of the σ scores of corresponding X and Y measures i.e. The graphical representation of the two variables will be a curved line. Such a relationship between the two variables is termed as the curvilinear correlation. The size of ‘r‘ indicates the amount of correlation-ship between two variables.


The meaning and types of correlation of determination is a measure used in statistical analysis to assess how well a model explains and predicts future outcomes. Simplify linear regression by calculating correlation with software such as Excel. Understanding the correlation between two stocks and its industry can help investors gauge how the stock is trading relative to its peers.

The value of Pearson’s Correlation Coefficient lies between positive 1 and a negative 1. When the value of the coefficient is above +1 and less than – 1, the data is considered to be unrelated to each other. Data sets are considered to be in positive correlation if their coefficient is +1 and the data sets are considered to be in a negative correlation if their coefficient is -1.

Calculating ρ

Non-Gaussian Distributed Dataset Spearman’s correlation formulation may also be derived from the covariance correlation formula by adding a ranking of the variables to the formulation. The direction of the correlation coefficients Every correlation coefficients contain very unique description by means of its usage areas and aspects. Throughout this article, there will be four main correlation coefficients as Covariance, Pearson’s Spearman’s, and Polychoric Correlation Coefficient. The degree of intensity of relationship between two variables is measured with the coefficient of correlation.

Simple linear regression describes the linear relationship between a response variable and an explanatory variable using a statistical model. In the financial markets, the correlation coefficient is used to measure the correlation between two securities. For example, when two stocks move in the same direction, the correlation coefficient is positive. Conversely, when two stocks move in opposite directions, the correlation coefficient is negative.

When the variable \(x\) increases, the variable \(y\) decreases. Although correlation measures the direction and degree of correlation, it does not say anything about the cause-and-effect relationship between two or more variables. The previous statistical approaches are limited to analyzing a single variable or statistical analysis. This type of statistical analysis in which one variable is involved is known as univariate distribution. However, there are instances in real-world situations where distributions have two variables like data related to income and expenditure, prices and demand, height and weight, etc.

Difference between Correlation and Regression

The coefficient of correlation is used quite profitably in Prediction. In a number of studies it is used to predict the success one will achieve in his further educational careers. Correlation is very important in the field of Psychology and Education as a measure of relationship between test scores and other measures of performance. With the help of correlation, it is possible to have a correct idea of the working capacity of a person.

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The product-moment correlation can be shown in straight line which is known as linear correlation. The size of “r” is very much dependent upon the variability of measured values in the correlated sample. The greater the variability, the higher will be the correlation, everything else being equal. In order to observe the effect on the coefficient correlation r when a constant is added to one or both the variables, we consider an example. For this reason—even when working with short ungrouped series—it is often easier to assume means, calculate deviations from these A.M.’s and apply the formula .

Types of correlation:

If the variables are independent, Pearson’s correlation coefficient is 0, but the converse is not true because the correlation coefficient detects only linear dependencies between two variables. Pearson correlation coefficient parameter may be observed in five different ranges according to the variables’ current location lie on the x and y-axis, correlation’s range may subject to change. By using this coefficient, the direction of the features can be presumed. However, in the need of measuring the dependency of the variables, an additional metric shall be selected since the covariance coefficient cannot respond to this relationship. In the data, the features may have an increasing or decreasing relationship between them as depicted below.


The p-value gives us proof that we can justify the fact that the population correlation coefficient is different from zero, depending on what we observe from the sample. The Spearman’s correlation coefficient can be used when the data is skewed, is ordinal in nature and is robust when extreme values are present. For example, a trader might use historical correlations to predict whether a company’s shares will rise or fall in response to a change in interest rates or commodity prices. Similarly, a portfolio manager might aim to reduce their risk by ensuring that the individual assets within their portfolio are not overly correlated with one another.

Need for Correlation:

Now you can simply read off the coefficient right from the screen . Remember, if r doesn’t show on your calculator, then diagnostics need to be turned on. This is also the same place on the calculator where you will find the linear regression equation and the coefficient of determination.

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The most common of these is the Pearson correlation coefficient, which is sensitive only to a linear relationship between two variables . Other correlation coefficients – such as Spearman’s rank correlation – have been developed to be more robust than Pearson’s, that is, more sensitive to nonlinear relationships. Mutual information can also be applied to measure dependence between two variables. Non-parametric tests of rank correlation coefficients summarize non-linear relationships between variables. The Spearman’s rho and Kendall’s tau have the same conditions for use, but Kendall’s tau is generally preferred for smaller samples whereas Spearman’s rho is more widely used. The most common method, the Pearson product-moment correlation, is discussed further in this article.


This property reveals that if we divide or multiply all the values of X and Y, it will not affect the coefficient of correlation. Negative Correlation – When the variables are changing in the opposite direction , we call it as a negatively correlated. For e.g. alcohol consumption and lifeline, smartphones usages and battery lifeline, etc. The correlation is called as non-linear or curvilinear when the amount of change in one variable does not bear a constant ratio to the amount of change in the other variable. For example, if the amount of fertilizers is doubled the yield of wheat would not be necessarily be doubled. It is very useful for Economists to study the relationships between variables.

  • Finding the linear correlation coefficient requires a long, difficult calculation, so most people use a calculator or software such as Excel or a statistics program.
  • When two variables are correlated, the value of one variable can be estimated using the value of the other.
  • Correlation coefficient is independent of the change of origin and scale.
  • The co-efficient of correlation is always symbolized either by r or ρ .
  • They are free, or independent, of some characteristics of the population distribution.

When the mean is in decimals, then the calculation of deviations from the mean may become tedious. It is a preliminary step of investigating the relationship between two variables. It helps in understanding the behaviour of various economic variables like, demand, supply, GDP, interest, money supply, inflation, income and expenditure and so on. Interactive Flash simulation on the correlation of two normally distributed variables by Juha Puranen.

Covariance is a measure of how two variables change together. However, its magnitude is unbounded, so it is difficult to interpret. The normalized version of the statistic is calculated by dividing covariance by the product of the two standard deviations. Each x and y deviation is then expressed as a ratio, and is a pure number, independent of the test units. The sum of the products of the σ scores column divided by N yields a ratio which is a stable expression of relationship. This ratio is the “product-moment” coefficient of correlation.

There is a high correlation between aptitude in a subject at school and the achievement in the subject. At the end of the school examinations will this reflect causal relationship? Now, calculate dx.dy each row of distribution – X by multiplying the dx entries of each row by dy entries of each row. Then calculate dx.dy for each column of distribution – Y by multiplying dy entries of each column by the dx entries of each column.

In column 3, the students A and B, C and F and G and J are also getting the same scores, which are 16, 24 and 14 respectively. The correlation between Trial I and II is positive and very high. Look carefully at the scores obtained by the 10 students on Trial I and II of the test. Each difference of ranks of column 6 is squared and recorded in column 7. If the ranks are the same for both tests, each rank difference will be zero and ultimately D2 will be zero.

When interpreting correlation, it’s important to remember that just because two variables are correlated, it does not mean that one causes the other. A negative correlation, or inverse correlation, is a key concept in the creation of diversified portfolios that can better withstand portfolio volatility. Both the variables may be affected by some external factor. There is no correlation between the price of wheat and price of wine. With the increase in one variable other increases or decreases, but it is not necessary that this change is due to the change in first variable.

In case of a weak correlation, the average of one variable is related to the other, but there are plenty of exceptions. A correlation of 0 means there is no relationship between the two variables. Positive correlation is a relationship between two variables in which both variables move in tandem. An inverse correlation is a relationship between two variables such that when one variable is high the other is low and vice versa.

The closer the value of r comes to -1.00 or +1.00, the stronger the correlation. The closer the value of r comes to the number 0, the weaker the correlation. For example, if r equaled -.90 or .90 it would indicate a stronger relationship than -.09 or .09. Correlation knowledge allows us to predict the direction and intensity of change in a variable when the correlated variable changes. Positive, negative, zero, simple, multiple, partial, linear, and non-linear correlations are some of the frequently used types of correlations.