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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 reviews historical data on commodity futures and finds that the average pairwise correlation among a broad group of commodity returns is low in calm periods. Which statement best describes what Hull-style empirical studies of correlation in other asset classes generally find about how correlation behaves when markets are stressed?

Correlations among risky assets typically rise during stressed markets. Diversification benefits therefore shrink just when investors need them most, so models that assume constant or falling correlation in crises understate portfolio risk and potential losses.

  1. ACorrelations among risky assets tend to rise in stressed markets, reducing diversification benefitsCorrect
  2. BCorrelations among risky assets tend to fall toward zero in stressed markets, increasing diversification benefits
  3. CCorrelations remain exactly constant across market regimes
  4. DCorrelations become perfectly negative across all asset classes

Explanation

Empirical evidence across equities, bonds, commodities and other asset classes shows that correlations tend to increase during crises and downturns. This weakens diversification precisely when it is most needed. Assuming constant or falling correlation would understate portfolio risk.

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