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FRM Part II · FRM Exam Part II · Correlation Basics: Definitions, Applications, and Terminology

A portfolio manager observes that the correlation between a stock's returns and a bond index is negative in most years but turned strongly positive during a high-inflation period. Which conclusion is most appropriate for risk management?

Correlations are unstable across regimes, so diversification assumptions should be stress tested. A stock-bond correlation that flips from negative to positive in high inflation shows that historical estimates may not hold, so hedges relying on negative correlation can fail.

  1. ACorrelation is constant, so the sample estimate is reliable for any period
  2. BCorrelations are unstable across regimes, so diversification assumptions should be stress testedCorrect
  3. CNegative correlation guarantees hedging effectiveness
  4. DPositive correlation implies the bond has lower volatility

Explanation

Correlations change with macroeconomic regimes, so a historical estimate can mislead. Stress testing alternative correlation levels is prudent. No guarantee of hedging exists, and correlation says nothing about relative volatility.

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