VC GLOSSARY

In the financial realm, correlation is a measurement of the relationship between two securities. The correlation coefficient is expressed as a number between -1.0 and 1.0.

If the correlation coefficient is -1.0, the two securities are moving in opposite directions. If the number is at 1.0, the two securities move in the same direction. A correlation coefficient of 0 means the two securities have no linear relationship.

The correlation formula is:

It’s recommended that you use a software tool like Microsoft Excel to calculate the correlation coefficient. This is done using the CORREL formula function in Excel.

Let’s look at an example for calculating the correlation coefficient manually.

There are two holdings named Company A and Company B, with data from the previous three years being analyzed.

Step One: First obtain the average price of both companies in the desired timeframe.

The average price of Company A between 2018 and 2020 is $55.97 [(44.01 + 55.78 + 68.13) / 3) = 55.97].

The average price of Company B between 2018 and 2020 is $76.93 [(62.87 + 77.02 + 90.89) / 3) = 76.93].

Step Two: Next, take each price and subtract its respective average.

Start by taking the price of Company A in 2018 (44.01) and subtracting the average of Company A (55.97) to equal -11.96. Repeat this for the prices of Company A in 2019 and 2020. The results of these equations are in column a.

Next, take the price of Company B in 2018 (62.87) and subtract the average of Company B (76.93) to equal -14.06. Repeat this for the prices of Company B in 2019 and 2020. These results are in column b.

Step Three: Then multiply the variables in column a by their respective variables in column b and then calculate the sum of these results.

This is done by multiplying -11.96 (column a) by -14.06 (column b) in the first row to get a result of 168.16 and repeat the process for the next two rows. Finally, add the results together and for the sum at the bottom of the column (337.89).

Step Four: Take the values in column a and column b and square them.

Start with column a in 2018 (11.96^2 = 143.04) and repeat for all the values in both columns. Then find the sum of a^2 and b^2 listed at the bottom of the columns.

Finally, plug the numbers into the formula below, resulting in a correlation coefficient of 0.9998.

This means Company A and Company B have a very high correlation with each other.

The correlation coefficient formula has a number of uses when calculating the relationship between two variables. One example would be to compare the price of a commodity with the stock price of a company that produces that commodity. Similarly, the formula could also be used to calculate the correlation between the availability of a raw material (such as steel) and the output of a company that requires that material.

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