How to Manage Correlation Risk

Correlation risk can relate to stock predictions.

Correlation risk refers to the risk that two assets will not move up or down in value in a manner predicted by expected correlation. For example, you might expect that a specific oil company's stock price will go up just as the price of oil increases. Their expected correlation would be 1.0, or perfectly correlated. Actual results, however, might show that the oil company and the price of oil are only correlated to a level that is lower than 1.0.

Things You'll Need

• Calculator
• Internet access

Instructions

1. Assume that an investor has $1,000 invested in an oil company's stock and $1,000 invested in oil.

2. Study the results of both investments over a period of time.

3. Calculate the correlation of the price changes of the two investments.

4. Determine if the correlation is lower than 1.0. As an example, pretend that the correlation turns out to be 0.75.

5. Conduct market research to find a stock that has a correlation to oil of 0.25.

6. Sell $250 of the oil company stock, and buy $250 of the stock in the company that has a correlation of 0.25 to the price of oil. The $1,000 investment in the two stocks will now have a combined correlation to oil of 1.0, meaning that the correlation risk has been managed.

References

• "Investments, 7th Edition"; Zvi Bodie, Alex Cane and Alan J. Marcus; 2008.
• Online Business Dictionary: Correlation risk