Objectives: 1. Define correlation.

2. Apply correlation.
Correlation - Correlation” is a statistical term describing the degree to which two
variables move in coordination with one-another. If the two variables move in the same
direction, then those variables are said to have a positive correlation. If they move in
opposite directions, then they have a negative correlation. Understanding Correlation
The correlation coefficient (ρ) is a measure that determines the degree to which the
movement of two different variables is associated. The most common correlation
coefficient, generated by the Pearson product-moment correlation, is used to measure
the linear relationship between two variables. However, in a non-linear relationship, this
correlation coefficient may not always be a suitable measure of dependence.

The possible range of values for the correlation coefficient is -1.0 to 1.0. In other words,
the values cannot exceed 1.0 or be less than -1.0. A correlation of -1.0 indicates a
perfect negative correlation, and a correlation of 1.0 indicates a perfect positive
correlation. If the correlation coefficient is greater than zero, it is a positive relationship.
Conversely, if the value is less than zero, it is a negative relationship. A value of zero
indicates that there is no relationship between the two variables.

FORMULA

where:

 rxy – the correlation coefficient of the linear relationship between the variables x
and y
 xi – the values of the x-variable in a sample
 x̅ – the mean of the values of the x-variable
 yi – the values of the y-variable in a sample
 ȳ – the mean of the values of the y-variable
 In order to calculate the correlation coefficient using the formula above, you must
undertake the following steps:

1.Obtain a data sample with the values of x-variable and y-variable.

2. Calculate the means (averages) x̅ for the x-variable and ȳ for the y-variable.
3.For the x-variable, subtract the mean from each value of the x-variable (let’s call this
new variable “a”). Do the same for the y-variable (let’s call this variable “b”).
4. Multiply each a-value by the corresponding b-value and find the sum of these
multiplications (the final value is the numerator in the formula).
5. Square each a-value and calculate the sum of the result
6. Find the square root of the value obtained in the previous step (this is the
denominator in the formula).

7. Divide the value obtained in step 4 by the value obtained in step 7.

You can see that the manual calculation of the correlation coefficient is an extremely
tedious process, especially if the data sample is large. However, there are many
software tools that can help you save time when calculating the coefficient.
The CORREL function in Excel is one of the easiest ways to quickly calculate the
correlation between two variables for a large data set.
Example of Correlation
John is an investor. His portfolio primarily tracks the performance of the S&P 500 and
John wants to add the stock of Apple Inc. Before adding Apple to his portfolio, he
wants to assess the correlation between the stock and the S&P 500 to ensure that
adding the stock won’t increase the systematic risk of his portfolio. To find the
coefficient, John gathers the following prices for the last five years (Step 1):
Using the formula above, John can determine the correlation between the prices of the
S&P 500 Index and Apple Inc.
First, John calculates the average prices of each security for the given periods (Step
2):

After the calculation of the average prices, we can find the other values. A summary of
the calculations is given in the table below:

Using the obtained numbers, John can calculate the coefficient:

 The coefficient indicates that the prices of the S&P 500 and Apple Inc. have a high
positive correlation. This means that their respective prices tend to move in the same
direction. Therefore, adding Apple to his portfolio would, in fact, increase the level of
systematic risk.

Solve the correlation. Manual

Students Test x Test y
1 21 27
2 22 28
3 28 27
4 27 10
5 48 30
6 22 21
7 27 27
8 6 21
9 11 21
10 12 28
11 16 30
12 28 21

STUDENTS X (X - x̅ ) Y Y-Y (X - x̅ ) (Y
– Y)

.333333333 = 1/3
0.3 = 3/10
1/3 ? 3/10
333.33
300.00