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FRM Part II · FRM Exam Part II · Empirical Properties of Correlation: How Do Correlations Behave in the Real World?

A bank's economic-capital model uses a single average credit-default correlation estimated over a long expansion. Based on empirical evidence about correlation and the business cycle, what is the most likely consequence during a severe recession?

Capital will likely be understated. Default correlations tend to rise along with default rates in recessions, which fattens the portfolio loss tail. A model calibrated to a long expansion's average correlation will underestimate tail losses and the capital needed to absorb them.

  1. ACapital will be overstated because default correlations fall in recessions
  2. BCapital will be understated because default correlations and default rates tend to rise together in recessionsCorrect
  3. CCapital will be unaffected because default correlation is constant over the cycle
  4. DCapital will be overstated because volatility declines in recessions

Explanation

Empirically, default correlations and default rates rise in recessions, producing a fatter loss tail. A model calibrated to expansion-period average correlation therefore understates tail losses and capital. The opposite claims contradict this evidence.

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