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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 observes that average pairwise equity correlation spiked to 0.85 during a market sell-off, versus a long-run average of 0.40. Assuming correlation is mean reverting, which implication is most appropriate for risk management?

Short-horizon risk should use the elevated correlation, while long-horizon estimates can lean toward the long-run average. Mean reversion means the spike matters now but decays over time, so neither ignoring it nor assuming it persists forever is appropriate.

  1. AStress-period correlations will persist indefinitely, so the 0.85 should be used for all long-horizon VaR
  2. BShort-horizon risk should reflect the elevated correlation, but long-horizon diversification estimates may rely more on the long-run levelCorrect
  3. CCorrelation should be assumed unrelated to market conditions in setting scenarios
  4. DBecause correlation reverts, a stress correlation need not be considered for short horizons

Explanation

With mean reversion, current high correlation matters in the near term but decays toward the long-run mean over longer horizons. Using 0.85 permanently overstates long-term risk, while ignoring it understates short-term risk.

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