Positive Correlation Definition Types Top 5 Examples

Positive Correlation Definition

Explanation

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COV(X,Y) = Covariance between X and Y

SDX = Standard Deviation of XSDY = Standard Deviation of Y

Types

There are mainly three types of positive correlations –

#1 – Strong Correlation (+1.0)

When one variable moves in one direction, other variables also move in the same direction to the same degree, which is strong. It ranges from greater than “+0.8” to “+1.0”. A correlation of +1 indicates that the variables are perfectly positively correlated. It means if one variable moves by 10%, other variables will also move by 10% in the same direction. So, it gives both strength and direction.

#2 – Medium Correlation (+0.5)

When one variable moves in one direction, other variables also move in the same direction, but their degree is not the same. For example, say one stock increases by 10%, and another stock increases by 5%, then both the stocks move in the same direction, but the magnitude is not the same.

#3- Low Correlation (+0.2)

Here, both variables move in the same direction, but the degree differs immensely. For example, if one variable gives a return of 10%, then another may give a return of 2%. So seeing this, one may predict that they will move in the same direction, but the movement is small to gain from.

Examples of Positive Correlation

Below are the examples to understand the concept in a better way –

Example #1

When the price of petrol increases, the demand for electric cars increases. So, every time a petrol price increases, it has been found that demand for electric cars has increased, say the correlation between both the products is +0.8.

Example #2

Beta in FinanceBeta In FinanceBeta is a financial metric that determines how sensitive a stock’s price is to changes in the market price (index). It’s used to analyze the systematic risks associated with a specific investment. In statistics, beta is the slope of a line that can be calculated by regressing stock returns against market returns.read more. measures the correlation between stocks and markets. So, for example, if a stock has a beta of 1, then it means that if the market, on average, gives a 10% return, then the stock will also give a 10% return. So, it moves exactly like the market.

If a stock with Beta 1 is added to the portfolio replicating Stock IndexStock IndexThe stock index, which is also known as the stock market index, is a tool used to determine the performance of shares/securities in the market and to calculate the return on the stock of their investment investors use it to have knowledge about the performance of investments and access the total value they possess.read more, then the portfolio’s risk will remain unchanged. Adding a stock with a Beta of 0.5 will decrease the portfolio’s overall risk as the stock is less risky than the market. Similarly, a stock with a Beta of more than 1 will increase the portfolio’s overall risk.

Example #3

It empirically found that when a country’s GDP increases, the demand for luxury goods also increases. So, the demand for luxury goods and GDP have a positive correlation.

Example #4

The price of the bond positively correlates to the coupon rate. Therefore, if the Coupon Rate of a BondCoupon Rate Of A BondThe coupon rate is the ROI (rate of interest) paid on the bond’s face value by the bond’s issuers. It determines the repayment amount made by GIS (guaranteed income security). Coupon Rate = Annualized Interest Payment / Par Value of Bond * 100%read more is high, then its price will also be high as the bond is giving higher coupons so that the bond will be more attractive in the market, and its price will also start to rise to ignore the risk of the bond.

Example #5

As the export of a particular country increases, the demand for the home currency in the international currency market increases because people will need your home currency to make payments for the goods purchased from your country. So, the home currency starts appreciatingCurrency Starts AppreciatingCurrency appreciation is a rise in the value of a national currency over the importance of international currencies due to an increase in the demand for domestic currency in a global market, a rise in inflation and interest rates, and flexibility of fiscal policy or government borrowing.read more. Therefore, it is a positive correlation between currency and exports.

Positive Correlation vs Negative Correlation

Positive correlation shows the positive linear movement of variables in the same direction. For example, if one stock increases and another increases, that is a positive correlation. A negative correlationNegative CorrelationA negative correlation is an effective relationship between two variables in which the values of the dependent and independent variables move in opposite directions. For example, when an independent variable increases, the dependent variable decreases, and vice versa.read more is where both variables act in the opposite direction. If one stock increases and the other decreases, they show a negative correlation. Many commodities, stocks, and other financial instrumentsFinancial InstrumentsFinancial instruments are certain contracts or documents that act as financial assets such as debentures and bonds, receivables, cash deposits, bank balances, swaps, cap, futures, shares, bills of exchange, forwards, FRA or forward rate agreement, etc. to one organization and as a liability to another organization and are solely taken into use for trading purposes.read more find positive and negative correlations.

Conclusion

A positive correlation is a very important measure that helps us to estimate the degree of the positive linear relationshipLinear RelationshipA linear relationship describes the relation between two distinct variables - x and y - in the form of a straight line on a graph. When presenting a linear relationship through an equation, the value of y is derived through the value of x, reflecting their correlation.read more between two variables. It is the most important measure that investors and fund managers use to increase or decrease risk in a portfolio. In addition, it helps us to predict many financial downturns. For example, suppose a particular market is positively related to GDP. If the GDP falls, one can predict that the market will also fall. So, tracking correlations between variables will help us understand one variable’s movement concerning another.