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FRM Part II · FRM Exam Part II · Financial Correlation Modeling - Bottom-Up Approaches

A risk analyst is explaining why a bank's models for correlated defaults differ from the models used for correlated equity returns. Which statement best describes a defining feature of financial correlation (as opposed to standard statistical correlation)?

Financial correlation describes dependence among financial variables, including defaults, spreads and asset values, which are often non-normal. It is not restricted to Pearson correlation of returns, is not confined to positive values, and varies with the time horizon, so the broader definition is correct.

  1. AIt is calculated only from historical Pearson coefficients of daily returns
  2. BIt measures the dependence of financial variables such as asset values, default events or credit spreads, and can be applied to non-normal events like defaultsCorrect
  3. CIt is always bounded between 0 and 1 because defaults cannot be negative
  4. DIt is independent of the time horizon over which it is measured

Explanation

Financial correlation covers dependence among financial variables including default times and events, which are not normally distributed. It is not limited to Pearson returns correlation, is bounded between -1 and 1, and depends on the horizon. The other options misstate these properties.

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