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FRM Part II · FRM Exam Part II · Empirical Properties of Correlation: How Do Correlations Behave in the Real World?

A risk analyst reviewing equity correlation data from Hull's empirical-correlation discussion observes that average pairwise correlations among large-cap stocks have historically been higher during recessions than during expansions. Which conclusion is most consistent with this empirical finding?

Equity correlations tend to be higher in recessions than expansions, so diversification weakens exactly when it is needed. Using expansion-period correlations would therefore understate portfolio risk in downturns, which is why stressed or state-dependent correlation estimates are advisable.

  1. ADiversification benefits tend to be weaker in recessions, so portfolio risk is understated if expansion-period correlations are usedCorrect
  2. BDiversification benefits tend to be stronger in recessions because stocks respond to different idiosyncratic shocks
  3. CCorrelations are independent of the economic state, so a single estimate suffices for all periods
  4. DCorrelations fall in recessions because volatility rises and dominates covariance

Explanation

Equity correlations rise in recessions, so the diversification benefit shrinks. Using calmer expansion-period correlations would understate portfolio risk in downturns. The option claiming stronger diversification reverses the empirical pattern.

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