Can any of the company-specific risk be diversified away by investing in both Merck and Ford at the same time? Although using a correlation coefficient on its own may not help to predict future stock returns, this module helps to understand the diversifiable risk of combining Merck and Ford into the same portfolio, which is an essential part of the fundamental portfolio management process.
By analyzing existing cross correlation between Merck Company and Ford Motor, you can compare the effects of market volatilities on Merck and Ford and check how they will diversify away market risk if combined in the same portfolio for a given time horizon. You can also utilize pair trading strategies of matching a long position in Merck with a short position of Ford. Check out your portfolio center. Please also check ongoing floating volatility patterns of Merck and Ford.
The 3 months correlation between Merck and Ford is 0.65. Overlapping area represents the amount of risk that can be diversified away by holding Merck Company and Ford Motor in the same portfolio, assuming nothing else is changed. The correlation between historical prices or returns on Ford Motor and Merck is a relative statistical measure of the degree to which these equity instruments tend to move together. The correlation coefficient measures the extent to which returns on Merck Company are associated (or correlated) with Ford. Values of the correlation coefficient range from -1 to +1, where. The correlation of zero (0) is possible when the price movement of Ford Motor has no effect on the direction of Merck i.e., Merck and Ford go up and down completely randomly.
Considering the 90-day investment horizon Merck Company is expected to generate 0.45 times more return on investment than Ford. However, Merck Company is 2.2 times less risky than Ford. It trades about 0.07 of its potential returns per unit of risk. Ford Motor is currently generating about -0.02 per unit of risk. If you would invest 6,998 in Merck Company on September 5, 2023 and sell it today you would earn a total of 3,348 from holding Merck Company or generate 47.84% return on investment over 90 days.
Over the last 90 days Merck Company has generated negative risk-adjusted returns adding no value to investors with long positions. Despite quite persistent basic indicators, Merck is not utilizing all of its potentials. The latest stock price mess, may contribute to short-term losses for the institutional investors.
Over the last 90 days Ford Motor has generated negative risk-adjusted returns adding no value to investors with long positions. Despite latest weak performance, the Stock's technical and fundamental indicators remain stable and the current disturbance on Wall Street may also be a sign of long-run gains for the company stockholders.
The main advantage of trading using opposite Merck and Ford positions is that it hedges away some unsystematic risk. Because of two separate transactions, even if Merck position performs unexpectedly, Ford can make up some of the losses. Pair trading also minimizes risk from directional movements in the market. For example, if an entire industry or sector drops because of unexpected headlines, the short position in Ford will offset losses from the drop in Ford's long position.
The idea behind Merck Company and Ford Motor pairs trading is to make the combined position market-neutral, meaning the overall market's direction will not affect its win or loss (or potential downside or upside). This can be achieved by designing a pairs trade with two highly correlated stocks or equities that operate in a similar space or sector, making it possible to obtain profits through simple and relatively low-risk investment.
Check out your portfolio center.Note that this page's information should be used as a complementary analysis to find the right mix of equity instruments to add to your existing portfolios or create a brand new portfolio. You can also try the Equity Valuation module to check real value of public entities based on technical and fundamental data.
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