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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 the correlation between a stock index and a bond index has been 0.10 on average over ten years, but in the last year equity returns were strongly negative and the correlation of the two rose sharply to 0.60. Which interpretation best reflects the empirical evidence on correlation and market states?

The jump is consistent with empirical findings that correlations tend to be higher in volatile and falling markets. Correlation depends on market state, so diversification benefits shrink in stress, which makes the observed increase expected rather than an error.

  1. AThe result is a statistical error because correlation cannot depend on market state
  2. BCorrelations tend to be higher in volatile or down markets, so the shift is consistent with known behaviorCorrect
  3. CCorrelations rise only when markets rise strongly
  4. DCorrelation and volatility are empirically unrelated

Explanation

Empirical work finds correlations increase in periods of high volatility and especially in market downturns, so diversification weakens when needed most. The other options contradict this evidence.

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