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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 of hedge funds observes that returns of several hedge fund strategies show low correlation with each other during tranquil markets but converge sharply in a liquidity crisis. Which explanation is most consistent with this behavior?

Hedge fund strategy correlations converge in liquidity crises because strategies share exposure to funding and market liquidity. Margin calls and forced deleveraging cause simultaneous selling, creating joint losses even among strategies that look unrelated in calm markets.

  1. AStrategies share common exposure to funding and liquidity conditions, so forced deleveraging drives joint lossesCorrect
  2. BHedge fund strategies hold identical securities at all times
  3. CCorrelation estimates are always biased upward in calm markets
  4. DHedge funds are prohibited from using leverage during crises

Explanation

Different strategies often rely on leverage and funding liquidity. In a crisis, margin calls and forced selling create common losses, raising correlation. Identical holdings are not required, and the other options are unsupported.

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