Business Analytics

Covariance and Correlation

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 Business Analytics

Covariance and Correlation

Correlation & Covariance
• Covariance and correlation describe how two variables
are related.
• Variables are positively related if they move in the same
direction.
• Variables are inversely related if they move in opposite
directions.
• Both covariance and correlation indicate whether
variables are positively or inversely related. Correlation
also tells you the degree to which the variables tend to
move together.

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Correlation
• When you say that two items correlate, you are saying
that the change in one item effects a change in another
item.

• You will always talk about correlation as a range between -

1 ,0 and 1. For example, if you say that two items have a
correlation of .9 you are saying that a change in one item
results in a similar change to another item.

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Correlation

• All the stock market indexes tend to move together in

similar directions. When the DOW Jones loses 5%, the
S&P 500 usually loses around 5%. When the DOW Jones
gains 5%, the S&P 500 usually gains around 5% because
they are highly correlated.

• There could also be negative correlation where you might

observe that as the DOW Jones loses 5% of it value, Gold
might gain 5%. Alternatively, if the Dow Jones gains 5% of
its value, Gold may lose 5% of its value.

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Covariance
• Covariance is a concept used in statistics and probability
theory to describe how two variables change when
compared to one another.
• Covariance is not standardized, unlike the correlation
coefficient.
• In business and investing, covariance is used to determine
different investments’ returns over a period of time in
relation to different variables. Usually the investment
assets are the marketable securities in a portfolio.

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Covariance
• A positive covariance means the assets’ returns move up
or down together. A negative covariance means they
move in opposite directions.

• Covariance is often used to measure movement relations

where the units of measure are different. For this reason,
covariance does not indicate the degree to which the two
items being measured move in relation to one another.

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Covariance
• For instance, if Asset A and Asset B have a negative
covariance, when Asset A has a positive return, Asset B
will have a negative return.
• However, if Asset A’s returns increase by 15%, covariance
will only tell you that Asset B’s returns will go down. The
amount could be 5%, 10%, etc.
• To determine the actual amount; you must first calculate
the correlation between the two assets’ units of
measure.

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Covariance
• A large covariance can mean a strong relationship
between variables.
• However, you can’t compare variances over data sets with
different scales (like pounds and inches).
• A weak covariance in one data set may be a strong one in
a different data set with different scales.
• The main problem with covariance is that the wide range
of results that it takes on makes it hard to interpret.

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Covariance
• For example, your data set could return a value of 3, or
3,000. This wide range of values is cause by a simple fact;
• The larger the X and Y values, the larger the covariance.
A covariance of 300 tells us that the variables are
correlated, but unlike the correlattion coefficient, that
number doesn’t tell us exactly how strong that
relationship is.
• The problem can be fixed by dividing the covariance by
the standard deviation to get the correlation coefficient

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Correlation

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R Code Correlation & Covariance
• Let us find whether there is Correlation between ice cream sales &
Temperature.
• Load xlsx package
• Create dataframe, “mydata”
>mydata<-
read.csv("C:/Users/User/Documents/R/icecream.csv“,header=TRUE)
>x<-mydata$Temperature
>y<-mydata$Sales
>cov(x,y)
484.0932
>cor(x,y)
0.9575066

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R Code Correlation & Covariance
> plot(x,y,xlab="Temperature",ylab="Sales")
> abline(lm(y~x),cov(x,y))
The correlation coefficient of the Temperature and
Sales is 0.9575066.
Since it is close to 1, we can conclude that the
variables are positively linearly related.

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Scatterplot showing +ve Correlation

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