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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 stress test for a credit portfolio uses the average default correlation observed over the past ten benign years. Which empirical property of default correlation most directly undermines this approach?

The key problem is that default correlations tend to increase during economic downturns. An average taken over ten benign years therefore understates the likelihood of clustered defaults in stress, making loss estimates too low for the conditions the stress test is meant to capture.

  1. ADefault correlations are independent of the credit cycle
  2. BDefault correlations are always negative among firms in the same industry
  3. CDefault correlations tend to rise in downturns, so benign-period estimates understate joint defaults in stressCorrect
  4. DDefault correlations are fully determined by firms' credit ratings

Explanation

Defaults cluster in recessions as common factors dominate, so default correlation is higher in bad times. Using a benign-period average understates the probability of many joint defaults in stress. The other statements contradict the evidence.

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