Investment strategies. One reason to invest abroad is that markets in different

Question

Investment strategies. One reason to invest abroad is that markets in different countries don move in step. When American stocks go down, foreign stocks may go up. So an investor who holds both bears less risk. Thats the theory But then we read in a magazine article that the correlation between changes in American and European stock prices rose from 0.4 in the mid- 1990s to 0.8 in 2000.1 Questions 7.34 and 7.35 refer to this article. Explain to an investor who knows no statistics why the fact stated in this article reduces the protection provided by buying European stocks. 7.34 The same article claiming that the correlation between changes in stock prices in Europe and the United States is 0.8 goes on to say: "Crudely, that means that movements on Wall Street can explain 80% of price movements in Europe. 7.35 (a) Is this true? rcent eynlained ifr 082

Explanation / Answer

7.34 Correlation coeffciient is a measure of strength and direction of two variables. Since, the value of Pearson correlation coeffcient is always between -1 and +1, a value of r close to -1 indicate strong, negative relationship and a value close to +1 indicate strong positive relationship between variables. Therefore, a value of r=0.4 means a low, positive linear relation between foreign stock and American stock, that is as American stock goes up, foreign stock too goes up but very slowly. But a correlation value of r=0.8 indicates strong positive relationship between variables, that is as American stock goes up, foreign stock increases too and that also at fast pace. Thus, two stocks hav esame direction but different strength. This explains the question asked.

7.35 a. Coefficient of determination, R^2 explains the change in variability of response variable (stock price in Wall street) accounted by the independent variable (stock price in Europe), not the correlation coefficent. Thus, the statement is not true.

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