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

A portfolio manager holds a diversified basket of equities and high-yield bonds. Over the past decade the rolling correlation between the two has been positive in most periods, while correlation between equities and government bonds has switched sign across regimes. Which conclusion is best supported by this evidence?

High-yield bonds embed credit risk tied to the same economic drivers as equities, so their correlation with equities is typically positive. Government bond and equity correlation changes sign with the macro regime, so it should not be treated as a fixed parameter.

  1. AEquity-to-government-bond correlation is a stable parameter and can be estimated once and fixed
  2. BHigh-yield bonds behave more like equity-linked credit risk, so their correlation with equities is structurally positive, while government bond correlation depends on the macro regimeCorrect
  3. CGovernment bonds always provide a hedge for equity losses regardless of regime
  4. DHigh-yield bonds and equities are driven by entirely unrelated factors

Explanation

High-yield bonds carry significant default and credit risk that shares the same economic drivers as equities, giving positive correlation. Government bond/equity correlation depends on whether inflation or growth shocks dominate, so it changes sign. Treating it as stable or always negative is wrong.

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