How Are Negative Correlations Used in Risk Management?

How Are Negative Correlations Used in Risk Management?

A negative correlation used in risk management between two variables is a statistical measure of their connection. It is common for one variable to decrease while the other grows, and vice versa, in the case of negatively linked variables. If two assets have a negative correlation, this may be utilized as risk management to reduce the overall portfolio risk.

Understanding Negative Correlations

When making a choice, it’s essential to weigh all potential outcomes, and one way to do this is through risk management. To choose the right course of action in light of the investment goals and risk tolerance connected with a portfolio, investors, portfolio managers, and risk managers utilize this concept to examine and quantify the degree of possible losses associated with an investment portfolio.

INTERNATIONALLY RELEVANT CONCLUSIONS

• When the prices of the two assets go in opposite directions, the correlation is negative.
• The term “risk management” refers to assessing and reducing portfolio dangers.
• Adding assets that are unrelated to one another to a portfolio helps reduce the overall risk and volatility.
• Due to the put’s negative correlation with the underlying instrument, purchasing one is a common strategy for reducing risk in stock portfolios and other investments.
• Portfolio risk management considers the inverse relationship between different investments while making allocation decisions. Portfolio managers and investors feel that assembling a portfolio of negatively correlated assets may mitigate some of the risks that come with the portfolio. A portfolio manager could collect negatively correlated assets if, for instance, they are expecting a market collapse or live in a period of high volatility.
• Portfolio managers frequently try to reduce the portfolio’s overall volatility by combining assets and using risk management strategies during periods of extreme market volatility. For example, making use of assets with which you have a negative correlation may lower your portfolio’s overall volatility.

Examples of Using Negative Correlations

• The oil industry is a prime target for an investor who manages a portfolio. However, oil stockpiles have been decreasing owing to a surplus of crude oil, which has resulted in a fifty percent drop in prices over the previous six months. The manager anticipates more declines and possibly a collapse in oil prices shortly, but they are interested in keeping the equities for the long haul.
• Diversifying the oil industry’s portfolio with assets that have a negative correlation will help mitigate risk. For example, aerospace, airlines, and the gambling industry negatively correlate with the oil industry. Therefore, to reduce his exposure to oil, the portfolio manager may sell some of his holdings there and instead purchase equities from the negatively linked industries.
• A portfolio manager may use hedging strategies to lessen the portfolio’s exposure to danger. The process of hedging minimizes the volatility of a portfolio or investment by securing profits from potential losses elsewhere. This exemplifies how negative correlations may be utilized in risk management. For example, the portfolio manager may reduce some of the risks in the oil sector by using negatively correlated assets rather than diversifying the portfolio, which can eat up too much of the available purchasing power.
• Buying put options on equities, for instance, is one method that may be used to lessen the portfolio’s overall exposure to risk. Buying put options will reduce portfolio risk since their value rises in tandem with a decline in the stock price. However, there is a fee and a risk associated with purchasing put options since their value declines as the stock price rises.