Africa Beza College Econometrics for Finance

Chapter 2: Correlation Theory

Pre-test Questions
1. How do you define correlation and covariance?
2. What is the difference between correlation and covariance?
3. What is correlation coefficient?
4. What are the types of correlation?
5. Which correlation measurement methods do you know?
2.1. Basic concepts of Correlation

Correlation Analysis
Economic variables have a great tendency of moving together and very often data are given in pairs of observations in
which there is a possibility that the change in one variable is on average accompanied by the change of the other variable.
This situation is known as correlation.

Correlation may be defined as the degree of relationship existing between two or more variables. The degree of
relationship existing between two variables is called simple correlation. The degree of relationship connecting three or
more variables is called multiple correlations. In this unit, we shall examine only simple correlation. A correlation is also
said to be partial if it studies the degree of relationship between two variables keeping all other variables connected with
these two are constant.
Correlation may be linear, when all points (X, Y) on scatter diagram seem to cluster near a straight, or nonlinear, when all
points seem to lie near a curve. In other words, correlation is said to be linear if the change in one variable brings a constant
change of the other. It may be non-linear if the change in one variable brings a different change in the other.

Correlation may also be positive or negative. Correlation is said to positive if an increase or a decrease in one variable is
accompanied by an increase or a decrease by the other in which both variables are changed with the same direction. For
example, the correlation between price of a commodity and its quantity supplied is positive since as price rises, quantity
supplied will be increased and vice versa. Correlation is said to negative if an increase or a decrease in one variable is
accompanied by a decrease or an increase in the other in which both are changed with opposite direction. For example, the
correlation between price of a commodity and its quantity demanded is negative since as price rises, quantity demanded
will be decreased and vice versa.
1. by the product of the units of the two variables.

Methods of Measuring Correlation

In correlation analysis there are two important things to be addressed. These are the type of co-variation existed between
variables and its strength. And the types of correlation mentioned before do not show to us the strength of co-variation
between variables. There are three methods of measuring correlation. These are:

1. The Scattered Diagram or Graphic Method

2. The Simple Linear Correlation coefficient

3. The coefficient of Rank Correlation

The Scattered Diagram or Graphic Method
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The scatter diagram is a rectangular diagram which can help us in visualizing the relationship between two phenomena. It
puts the data into X-Y plane by moving from the lowest data set to the highest data set. It is a non-mathematical method of
measuring the degree of co-variation between two variables. Scatter plots usually consist of a large body of data. The
closer the data points come together and make a straight line, the higher the correlation between the two variables, or the
stronger the relationship.
If the data points make a straight line going from the origin out to high x- and y-values, then the variables are said to have a
positive correlation. If the line goes from a high-value on the y-axis down to a high-value on the x-axis, the variables have
a negative correlation.

A perfect positive correlation is given the value of 1. A perfect negative correlation is given the value of -1. If there is
absolutely no correlation present the value given is 0. The closer the number is to 1 or -1, the stronger the correlation, or
the stronger the relationship between the variables. The closer the number is to 0, the weaker the correlation.

Two variables may have a positive correlation, negative correlation, or they may be uncorrelated. This holds true both for
linear and nonlinear correlation. Two variables are said to be positively correlated if they tend to change together in the
same direction, that is, if they tend to increase or decrease together.
Such perfect correlation is seldom encountered. We still need to measure correlational strength, defined as the degree to
which data point adhere to an imaginary trend line passing through the “scatter cloud.” Strong correlations are associated
with scatter clouds that adhere closely to the imaginary trend line. Weak correlations are associated with scatter clouds that
adhere marginally to the trend line. The closer r is to +1, the stronger the positive correlation.
The closer r is to -1, the stronger the negative correlation. Examples of strong and weak correlations are shown below.
Note: Correlational strength cannot be quantified visually. It is too subjective and is easily influenced by axis-scaling. The
eye is not a good judge of correlational strength.

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Such positive correlation is postulated by economic theory for the quantity of a commodity supplied and its price. When
the price increases the quantity supplied increases. Conversely, when price falls the quantity supplied decreases. Negative
correlation: Two variables are said to be negatively correlated if they tend to change in the opposite direction: when X
increases Y decreases, and vice versa. For example, saving and household size are negatively correlated. When price
increases, demand for the commodity decreases and when price falls demand increases.
2.2. Correlation coefficient and types of Correlation coefficient

The Population Correlation Coefficient ‘’ and its Sample Estimate ‘r’

In the light of the above discussions it appears clear that we can determine the kind of correlation between two variables by
direct observation of the scatter diagram. In addition, the scatter diagram indicates the strength of the relationship between
the two variables. This section is about how to determine the type and degree of correlation using a numerical result. For a
precise quantitative measurement of the degree of correlation between Y and X we use a parameter which is called the
correlation coefficient and is usually designated by the Greek letter. Having as subscripts the variables whose correlation
it measures,  refers to the correlation of all the values of the population of X and Y. Its estimate from any particular
sample (the sample statistic for correlation) is denoted by r with the relevant subscripts. For example if we measure the
correlation between X and Y the population correlation coefficient is represented by xy and its sample estimate by r xy. The

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simple correlation coefficient is used to measure relationships which are simple and linear only. It cannot help us in
measuring non-linear as well as multiple correlations. Sample correlation coefficient is defined by the formula:

u
ln(Y)=ln(β0 X β X 2 e )=ln(β0)+β1 ln (X1)+β2 ln(X2)+u
β

11 2 2.1

~ ~^ ^ ~ ^ ~
Y= β0+ β1 X1+ β2 X2+u
Or 2.2
~
Y = ln ( Y )
~
X 1 = ln ( X 1)
~
X 2 = ln ( X 2 )

Where,
~
^
β 0= l n ( β 0 )

Explanation of the Formula for r. The formulas presented above are those which are used to determine r. While the
calculation is relatively straightforward, although tedious, no explanation for the formula has been given. Here an intuitive
explanation of the formula is provided. Recall that the original formula for determining the correlation coefficient r for the
association between two variables X and Y is

r=
∑ ( X i− X )( Y i −Y )
√ ∑X √ ∑Y
2
2
( i −X ) ( i− X ) Or

The denominator of this formula involves the sums of the squares of the deviations of each value of X and Y about their
respective means. These summations under the square root sign in the denominator are the same expressions as were used

when calculating the variance and the standard deviation in Chapter 5. The expression ∑ ( X i −X )2 can be called the

variation in X. This differs from the variance in that it is not divided by n-1. Similarly, ∑ (Y i−Y )2 is the variation in Y.
The denominator of the expression for r is the square root of the products of these two variations. It can be shown
mathematically that this denominator, along with the expression in the numerator scales the correlation coefficient so that it
has limits of -1 and +1.
The numerator of the expression for r is

∑ ( X i −X )( Y i−Y )
and this is called the covariation of X and Y .
We will use a simple example from the theory of supply. Economic theory suggests that the quantity of a commodity
supplied in the market depends on its price, ceteris paribus. When price increases the quantity supplied increases, and vice
versa. When the market price falls producers offer smaller quantities of their commodity for sale. In other words, economic
theory postulates that price (X) and quantity supplied (Y) are positively correlated.

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Example 2.1: The following table shows the quantity supplied for a commodity with the corresponding price values.
Determine the type of correlation that exists between these two variables.

Table 1: Data for computation of correlation coefficient

Time period(in days) Quantity supplied Yi (in tons) Price Xi (in shillings)
1 10 2
2 20 4
3 50 6
4 40 8
5 50 10
6 60 12
7 80 14
8 90 16
9 90 18
10 120 20

To estimate the correlation coefficient we, compute the following results.

Table 2: Computations of inputs for correlation coefficients
~ ~
β^
Y X ^
β Y^ =e X X 0
x2
^β y2
β^ xiyi XY X2 Y2
0 1 2
1 2

10 2 -9 -51 81 2601 459 20 4 100

20 4 -7 -41 49 1681 287 80 16 400
50 6 -5 -11 25 121 55 300 36 2500
40 8 -3 -21 9 441 63 320 64 1600
50 10 -1 -11 1 121 11 500 100 2500
60 12 1 -1 1 1 -1 720 144 3600
80 14 3 19 9 361 57 1120 196 6400
90 16 5 29 25 841 145 1440 256 8100
90 18 7 29 49 841 203 1620 324 8100
120 20 9 59 81 3481 531 2400 400 14400
Sum=610 110 0 0 330 10490 1810 8520 1540 47700
Mean=61 11

Or using the deviation form (Equation 2.2), the correlation coefficient can be computed as:
u
Y =β0 X β1 e
1
This result shows that there is a strong positive correlation between the quantity supplied and the price of the commodity
under consideration.
The simple correlation coefficient has the value always ranging between -1 and +1. That means the value of correlation
coefficient cannot be less than -1 and cannot be greater than +1. Its minimum value is -1 and its maximum value is +1. If

r= -1, there is perfect negative correlation between the variables. If ln(Y)=ln(β 0 )+β1 ln(X 1)+ei , there is positive correlation between the

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two variables and movement from zero to positive one increases the degree of positive correlation. If r= +1, there is perfect
positive correlation between the two variables. If the correlation coefficient is zero, it indicates that there is no linear
relationship between the two variables. If the two variables are independent, the value of correlation coefficient is zero but
zero correlation coefficient does not show us that the two variables are independent.
Interpretation of Pearson’s Correlation Coefficient

The sign of the correlation coefficient determines whether the correlation is positive or negative. The magnitude of the
correlation coefficient determines the strength of the correlation. Correlation is an effect size and so we can verbally
describe the strength of the correlation using the guide that Evans (1996) suggests for the absolute value of r:

.00-.19 very weak”

.20-.39 “weak”
.40-.59 “moderate”
.60-.79 strong”
.80-1.0 “very strong”
For example a correlation value of r=0.42 would be a “moderate positive correlation”.
Properties of Simple Correlation Coefficient
The simple correlation coefficient has the following important properties:
1. The value of correlation coefficient always ranges between -1 and +1.
¿ −0.69
ln (Y )=9.121−0.69ln (X1) R2=0.992 ¿^=A. p (where A= antilog 9 .121 =^β )
0
2. The correlation coefficient is symmetric. That means (0.07) (0.02) , where, Y ¿ is the correlation coefficient of X on Y and
0.6 0.3
Yi=0.8 L K is the correlation coefficient of Y on X.
3. The correlation coefficient is independent of change of origin and change of scale. By change of origin we mean
subtracting or adding a constant from or to every values of a variable and change of scale we mean multiplying or dividing
every value of a variable by a constant.
4. If X and Y variables are independent, the correlation coefficient is zero. But the converse is not true.
5. The correlation coefficient has the same sign with that of regression coefficients.
6. The correlation coefficient is the geometric mean of two regression coefficients.
∑ Y =753 ∑ Y 2=48,139 ∑ YX1=40,830
∑ X 1=643 ∑ X 12=34 ,843 ∑ YX 2=6,796
∑ X 2=106 ∑ X 22=976 ∑ X 1 X2=5,779

Though, correlation coefficient is most popular in applied statistics and econometrics, it has its own limitations. The major
limitations of the method are:
1. The correlation coefficient always assumes linear relationship regardless of the fact whether the assumption is true or
not.
2. Great care must be exercised in interpreting the value of this coefficient as very often the coefficient is misinterpreted.
For example, high correlation between lung cancer and smoking does not show us smoking causes lung cancer.

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3. The value of the coefficient is unduly affected by the extreme values

5. The coefficient requires the quantitative measurement of both variables. If one of the two variables is not quantitatively
measured, the coefficient cannot be computed.
Definition of Covariance
Covariance is a statistical term, defined as a systematic relationship between a pair of random variables wherein a change
in one variable reciprocated by an equivalent change in another variable.
Covariance can take any value between -∞ to +∞, wherein the negative value is an indicator of negative relationship
whereas a positive value represents the positive relationship. Further, it ascertains the linear relationship between variables.
Therefore, when the value is zero, it indicates no relationship. In addition to this, when all the observations of the either
variable are same, the covariance will be zero.
In Covariance, when we change the unit of observation on any or both the two variables, then there is no change in the
strength of the relationship between two variables but the value of covariance is changed.
For two random variables, X Y their covariance is defined by cov(X ,Y) = E(X − EX )(Y − EY ),
Property 2. Alternative expression: cov(X ,Y ) = EXY − (EX )(EY ) .
Proof
cov(X,Y)

=E ( X−EX )(Y −EY )

=E [ XY −XEY −( EX )Y −( EX )( EY )] ( EX , EY are constants; use linearity)
=EXY −(EX )( EY )−(EX )(EY )+( EX )( EY )
=EXY −(EX )( EY )
Definition. Random variables, X Y are uncorrelated if cov(X ,Y) = 0 . Uncorrelatedness is close to independence, so the
intuition is the same: one variable does not influence the other. You can also say that there is no statistical relationship
between uncorrelated variables.
Key differences between covariance and correlation
The following points are noteworthy so far as the difference between covariance and correlation is concerned:
2. A measure used to indicate the extent to which two random variables change in tandem is known as covariance. A measure
used to represent how strongly two random variables are related known as correlation.
3. Covariance is nothing but a measure of correlation. On the contrary, correlation refers to the scaled form of covariance.
4. The value of correlation takes place between -1 and +1. Conversely, the value of covariance lies between -∞ and +∞.
5. Covariance is affected by the change in scale, i.e. if all the value of one variable is multiplied by a constant and all the
value of another variable are multiplied, by a similar or different constant, then the covariance is changed. As against this,
correlation is not influenced by the change in scale.
Correlation is dimensionless, i.e. it is a unit-free measure of the relationship between variables. Unlike covariance, where
the value is obtained.

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The Rank Correlation Coefficient

The formulae of the linear correlation coefficient developed in the previous section are based on the assumption that the
variables involved are quantitative and that we have accurate data for their measurement. However, in many cases the
variables may be qualitative (or binary variables) and hence cannot be measured numerically. For example, profession,
education, preferences for particular brands, are such categorical variables. Furthermore, in many cases precise values of
the variables may not be available, so that it is impossible to calculate the value of the correlation coefficient with the
formulae developed in the preceding section. For such cases it is possible to use another statistic, the rank correlation
coefficient (or spearman’s correlation coefficient.). We rank the observations in a specific sequence for example in order of
size, importance, etc., using the numbers 1, 2, 3… n. In other words, we assign ranks to the data and measure relationship
between their ranks instead of their actual numerical values. Hence, the name of the statistic is given as rank correlation
coefficient. If two variables X and Y are ranked in such way that the values are ranked in ascending or descending order,
the rank correlation coefficient may be computed by the formula

b1 b2 u
Y =bo L K e 2.3
Where,

D = difference between ranks of corresponding pairs of X and Y

n = number of observations.
The values that r may assume range from + 1 to – 1.
Two points are of interest when applying the rank correlation coefficient. Firstly, it does not matter whether we rank the
observations in ascending or descending order. However, we must use the same rule of ranking for both variables. Second
if two (or more) observations have the same value we assign to them the mean rank. Let’s use example to illustrate the
application of the rank correlation coefficient.
Example 2.2: A market researcher asks experts to express their preference for twelve different brands of soap. Their replies
are shown in the following table.
Table 3: Example for rank correlation coefficient
Brands of soap A B C D E F G H I J K L
Person I 9 10 4 1 8 11 3 2 5 7 12 6
Person II 7 8 3 1 10 12 2 6 5 4 11 9

The figures in this table are ranks but not quantities. We have to use the rank correlation coefficient to determine the type
of association between the preferences of the two persons. This can be done as follows.

Table 4: Computation for rank correlation coefficient

Brands of soap A B C D E F G H I J K L Total
Person I 9 10 4 1 8 11 3 2 5 7 12 6
Person II 7 8 3 1 10 12 2 6 5 4 11 9
Di 2 2 1 0 -2 -1 1 -4 0 3 1 -3

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Di2 4 4 1 0 4 1 1 16 0 9 1 9 50
The rank correlation coefficient (using Equation 2.3)

This figure, 0.827, shows a marked similarity of preferences of the two persons for the various brands of soap.

Partial Correlation Coefficients

A partial correlation coefficient measures the relationship between any two variables, when all other variables connected
with those two are kept constant. For example, let us assume that we want to measure the correlation between the number
of hot drinks (X1) consumed in a summer resort and the number of tourists (X 2) coming to that resort. It is obvious that
both these variables are strongly influenced by weather conditions, which we may designate by X 3. On a priori grounds we
expect X1 and X2 to be positively correlated: when a large number of tourists arrive in the summer resort, one should
expect a high consumption of hot drinks and vice versa. The computation of the simple correlation coefficient between X 1
and X2 may not reveal the true relationship connecting these two variables, however, because of the influence of the third
variable, weather conditions (X3). In other words, the above positive relationship between number of tourists and number
of hot drinks consumed is expected to hold if weather conditions can be assumed constant. If weather condition changes,
the relationship between X1 and X2 may change to such an extent as to appear even negative. Thus, if the weather is hot,
the number of tourists will be large, but because of the heat they will prefer to consume more cold drinks and ice-cream
rather than hot drinks. If we overlook the weather and look only at X 1 and X2 we will observe a negative correlation
between these two variables which is explained by the fact that hot drinks as well as number of visitors are affected by
heat. In order to measure the true correlation between X 1 and X2, we must find some way of accounting for changes in X 3.
This is achieved with the partial correlation coefficient between X 1 and X2, when X3 is kept constant. The partial correlation
coefficient is determined in terms of the simple correlation coefficients among the various variables involved in a multiple
relationship. In our example there are three simple correlation coefficients

r12 = correlation coefficient between X1 and X2

r13 = correlation coefficient between X1 and X3

r23 = correlation coefficient between X2 and X3

The partial correlation coefficient between X 1 and X2, keeping the effect of X3 constant is given by:

2.4
Similarly, the partial correlation between X 1 and X3, keeping the effect of X2 constant is given by:

and

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Example 2.3: The following table gives data on the yield of corn per acre(Y), the amount of fertilizer used(X 1) and the
amount of insecticide used (X2). Compute the partial correlation coefficient between the yield of corn and the fertilizer
used keeping the effect of insecticide constant.
Table 5: Data on yield of corn, fertilizer and insecticides used
Year 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980
Y 40 44 46 48 52 58 60 68 74 80
X1 6 10 12 14 16 18 22 24 26 32
X2 4 4 5 7 9 12 14 20 21 24
The computations are done as follows:

Table 6: Computation for partial correlation coefficients

Year Y X1 X2 Y x1 x2 x1y x2y x1x2 x12 x22 y2
1971 40 6 4 -17 -12 -8 204 136 96 144 64 289
1972 44 10 4 -13 -8 -8 104 104 64 64 64 169
1973 46 12 5 -11 -6 -7 66 77 42 36 49 121
1974 48 14 7 -9 -4 -5 36 45 20 16 25 81
1975 52 16 9 -5 -2 -3 10 15 6 4 9 25
1976 58 18 12 1 0 0 0 0 0 0 0 1
1977 60 22 14 3 4 2 12 6 8 16 4 9
1978 68 24 20 11 6 8 66 88 48 36 64 121
1979 74 26 21 17 8 9 136 153 72 64 81 289
1980 80 32 24 23 14 12 322 276 168 196 144 529
Sum 570 180 120 0 0 0 956 900 524 576 504 1634
Mean 57 18 12

ryx1=0.9854
ryx2=0.9917
rx1x2=0.9725
Then,

Limitations of the Theory of Linear Correlation

Just because two sets of data are correlated, it doesn't mean that one is the cause of the other.
Correlation analysis has serious limitations as a technique for the study of economic relationships.
Firstly: The above formulae for r apply only when the relationship between the variables is linear. However two variables
may be strongly connected with a nonlinear relationship.
It should be clear that zero correlation and statistical independence of two variables (X and Y) are not the same thing. Zero
correlation implies zero covariance of X and Y so that r=0. Statistical independence of x and y implies that the probability
of xi and yi occurring simultaneously is the simple product of the individual probabilities

P (x and y) = p (x) p (y)

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Independent variables do have zero covariance and are uncorrelated: the linear correlation coefficient between two
independent variables is equal to zero. However, zero linear correlation does not necessarily imply independence. In other
words uncorrelated variables may be statistically dependent. For example if X and Y are related so that the observations
fall on a circle or on a symmetrical parabola, the relationship is perfect but not linear. The variables are statistically
dependent.
Secondly, the second limitation of the theory is that although the correlation coefficient is a measure of the co-variability
of variables, it does not necessarily imply any functional relationship between the variables concerned. Correlation theory
does not establish, and/ or prove any causal relationship between the variables. It seeks to discover a co-variation exists,
but it does not suggest that variations in, say, Y are caused by variations in X, or vice versa. Knowledge of the value of r,
alone, will not enable us to predict the value of Y from X. A high correlation between variables Y and X may describe any
one of the following situations:
(1) variation in X is the cause of variation in Y,
(2) variation in Y is the cause of variation X,
(3) Y and X are jointly dependent, or there is a two- way causation, that is to say Y is the cause of (is determined by)
X, but also X is the cause of (is determined by) Y. For example in any market: q = f (p), but also p = f(q), therefore
there is a two – way causation between q and p, or in other words p and q are simultaneously determined.

(4) There is another common factor (Z), that affects X and Y in such a way as to show a close relation between them.
This often occurs in time series when two variables have strong time trends (i.e. grow over time). In this case we
find a high correlation between Y and X, even though they happen to be causally independent,
(5) The correlation between X and Y may be due to chance.

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