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

A commodity trader notes that the correlation between crude oil and natural gas futures returns is 0.30 over a long sample, yet in a two-month period of a major supply shock it is 0.80. Which interpretation is most appropriate for risk management?

Correlation changes across regimes, so the 0.30 long-run estimate and the 0.80 shock-period estimate both carry information. Risk managers should keep the long-run value for normal conditions and add stress scenarios using higher correlations rather than discarding either.

  1. AThe long-run figure is wrong and should be replaced by 0.80 permanently
  2. BCorrelation is regime dependent, so stress scenarios with higher correlation should supplement the long-run estimateCorrect
  3. CThe short-period figure is meaningless because correlation cannot exceed 0.50 for commodities
  4. DCorrelation differences imply that volatilities must also differ, so no action is required

Explanation

Correlation is time varying and rises in stress events. A sound approach keeps the long-run estimate for normal conditions but stress-tests with elevated correlation. Replacing it permanently ignores mean reversion, and there is no 0.50 cap.

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