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Key Financial Market Concepts, 2nd Edition by Bob Steiner

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Correlation and Covariance

Definition

Correlation and covariance are measures of the extent to which two things do, or do not, move together. The precise mathematical formulas are given below.

How are they used?

Consider for example the price of a 10-year government bond and the price of an 11-year government bond (issued by the same government). Generally, the price of one will rise and fall in line with the price of the other. The two prices are therefore closely correlated. On the other hand, when house prices rise, a government bond price might fall (because rising inflation pushes up interest rates), and vice versa. There might therefore be a negative correlation between government bond prices and the value of shares in a building materials ...

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