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CFA Level I · CFA Level I Exam · Statistical Characteristics of Asset Returns

Two return series have a sample correlation of 0.85. A portfolio manager concludes that a change in one asset's return causes the other's return to change. Which statement most accurately evaluates this conclusion?

The conclusion is unjustified. Correlation measures only the strength and direction of a linear relationship, and a high value may arise from a shared underlying factor, coincidence, or sampling error. Neither a high correlation nor a large covariance establishes causation.

  1. AIt is justified because a correlation above 0.80 is statistically conclusive of causation
  2. BIt is unjustified because correlation measures only linear association and may reflect a common factor or chanceCorrect
  3. CIt is justified only if the covariance is also greater than 1

Explanation

Correlation measures the strength of linear association, not causation. A high correlation may come from a common driver, spurious relationships, or sampling error. The size of the covariance is not relevant to causality because it depends on the units.

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