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

A risk analyst computes the Pearson correlation between daily returns of two equity indices and finds a value of 0.85. Which statement about this coefficient is most accurate?

Pearson correlation measures the strength and direction of the linear relationship between two variables. A value of 0.85 indicates strong positive linear association, but it does not prove causation, capture nonlinear dependence, or imply equal percentage moves.

  1. AIt measures the strength of the linear relationship between the two return seriesCorrect
  2. BIt shows that a change in one index causes a change in the other
  3. CIt captures any nonlinear dependence between the two indices
  4. DIt implies the two indices will always move by the same percentage amount

Explanation

Pearson correlation measures linear association only, scaled between -1 and +1. It does not establish causation, it can miss nonlinear dependence, and it says nothing about the magnitude of moves (that depends on volatilities).

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