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

A fund holds both domestic and foreign bonds and equities. Based on empirical findings on correlations across markets, which statement is most accurate regarding the benefits of international diversification?

Correlations between national equity markets tend to rise in crises, reducing diversification benefits just when investors need them. They are positive but below one in normal times, so international diversification still helps, but it is weaker under stress than average correlations suggest.

  1. ACorrelations between national equity markets rise in crises, reducing diversification benefits when they are most neededCorrect
  2. BInternational equity correlations fall in crises, increasing diversification benefits
  3. CCorrelations between national markets are zero in normal periods and one in crises
  4. DInternational diversification offers no benefit because correlations are always near one

Explanation

Empirically, cross-country equity correlations are positive but below one and increase during crises and high volatility, eroding diversification. They are not exactly zero normally, nor always near one, and they do not fall in crises.

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