Question

Q6: What is the Correlation Coefficient (Say between two stock returns over time)? How do standard deviations and covariance interact in this equation (show equation)? What is the correlation between stocks/bond market returns, and inflation/inflation expectations/interest rates over time? What does a -1, 0, and +1 correlation mean? Show Equation/Definition!!! and answer all questions!

Answer 1

The correlation coefficient is used to measure the relation between 2 securities, ranges values from -1 to +1 and indicates the strength between 2 stocks.

-1 indicates the stocks move in the opposite direction

i.e when one stock moves high the other goes down

+1 indicates the stock move in the same direction i.e both the stocks would either move upward or downward but in the same direction

0 indicated they are no relation between 2 stocks.

formula - Correlation =

cov(x,y) = covariance of 2 stocks

= standard deviation of 2 stocks

covariance shows how the securities are related and are calculated using the historical returns of the stocks and their mean difference.

Bond prices and interest rates are inversely correlated if the interest rate move up the old bonds becomes less attractive and prices decrease eventually.

Stocks and bonds are negatively correlated

There is no much relation between inflation and market returns, But when the interest rate is reduced people will have more money to spend which indeed increases the inflation rate.