Benefits of Portfolio Diversification

How to Measure Correlation Between Assets

In the previous episode, we showed you two ways to measure correlation. These were; coefficient of correlation (r) and coefficient of determination (R²). These are two widely used techniques for measuring correlation.

However, they do have their limitations.

When the quote currency in two fx pairs is the same, there will always be a correlation. However, due to the fundamental differences in base currency, they will also display uncorrelated behaviours.

This gives us an incorrect view whereby the (R²) number indicated a high level of correlation but the outlying data points highlighted the uncorrelated nature too. Talk about confusing.

A small change can have a big effect.

Today we’re going to make a subtle change that can provide a more robust view of the correlation between assets.

Instead of using price, we’re going to use the price difference. As an example, if we subtract an assets close price from the previous days’ close price, we can see the price change. It is this change in price that we will use for our new calculation.

Already you should be able to see the benefit of using this way. It allows us to compare price movements between the two assets.

We’ve given you a few examples of how correlation differs between assets and a few examples of different ways to measure correlation.

You can take this one step further by creating a correlation matrix in Excel for an indefinite number of assets.

Try doing the above to measure correlation between all the assets you have in your portfolio and see how diversified your asset selection is.

Darwinex helps you measure correlation of Darwins.

Darwinex has already done the hard work for you on the Darwinex platform by calculating the correlation between Darwins.

Remember a Darwin is an asset that tracks the performance of a traders underlying trading account, in real-time. Darwinex then manages the risk of the Darwin independently from the trader to target a max VaR (95%) of 6.5%.

To view the correlation between Darwins go to the correlation tab. It will show the correlation between the asset you have selected and a range of other Darwins. To check a particular darwin enter its ticker into the search box under the table to see the correlation between them.

Brought to you by Darwinex: UK FCA Regulated Broker, Asset Manager & Trader Exchange where Traders can legally attract Investor Capital and charge Performance Fees.

Risk disclosure:

Content Disclaimer: The contents of this video (and all other videos by the presenter) are for educational purposes only, and are not to be construed as financial and/or investment advice.