Correlation
Covariance rescaled to run from minus one to plus one, so co-movement can be compared across pairs. Anything below plus one pulls portfolio risk beneath the weighted average of the parts.
Where you will meet it
Correlation appears in 80 learning outcomes on the CFA syllabus. A few of them:
- Explain empirical duration and why it may diverge from analytical duration
“Empirical duration captures that correlation between the benchmark and the spread, which analytical duration assumes away by holding the spread constant.”
- Work out covariance and correlation and explain what they show
“Correlation divides covariance by the product of the two standard deviations, producing a unitless number bounded between -1 and +1 that can be compared across pairs.”
- Work out the variance of a portfolio made up of two assets
“Expressing covariance as the correlation times the two standard deviations makes the mechanism visible — the lower the correlation, the smaller the third term and the greater the reduction in risk relative to a simple weighted average.”
- Set out the main types of alternative investment
“Reported returns need care — valuations are frequently appraisal-based rather than market-based, which smooths returns and understates true volatility and correlation with public markets.”
See also
Practise it
Practise correlation until it is automatic: questions that explain every wrong option.
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