Correlation is a statistical measure of the degree to which two different assets move in relation to each other. Correlation in financial markets measures the degree of relationship between movements in the price indices of two assets between -1 and +1. These values indicate the direction and strength of the correlation. A +1 correlation means that the two assets are almost completely positively correlated, i.e. the two assets are moving in parallel. A correlation of -1 indicates an almost complete negative correlation, where one asset is moving in the opposite direction to the other. A correlation of 0 means there is no correlation between the movement of the two assets.

What is the usefulness of correlation?

Investors and traders use correlation to determine the diversification potential of an asset or portfolio. Portfolio diversification aims to reduce risk and optimize returns by selecting a variety of assets that are not highly correlated. When some assets are correlated, they move together and the portfolio that contains them will not be as diversified and may be at increased risk during market shifts. Using assets that show low correlation with each other helps mitigate this problem and improve a portfolio's risk/return ratio.

Three correlation coefficients are often used in financial research and analysis, which include:

• Pearson's correlation coefficient, which measures the linear correlation between two variables.
• Rand's correlation coefficient, which measures the correlation between two variables without assuming a linear relationship.
• Rank correlation coefficient, which is useful when there are multiple observations for each data point and the correlation is calculated using their respective ranks.

Each of these correlation coefficients can help identify and understand the relationship between different asset classes and select those that may be more appropriate for a diversified portfolio.

Conclusion

Financial analysts and researchers often use correlation analysis to determine the relationship between different securities or market indices in order to make better investment and trading decisions. By understanding the correlations between assets, investors can make more informed decisions and reduce the risk of their portfolios. Often these correlations are revised over time to ensure that they accurately reflect current relationships as markets are constantly changing and adjusting.