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

A risk analyst reviews the relationship between equity returns and equity volatility changes in a stress period. Historically, when equity indices fall sharply, implied volatility rises sharply. Which description of the correlation between equity returns and volatility changes is most consistent with this observation?

The correlation is strongly negative. When equity returns are sharply negative, implied volatility rises, so the two series move in opposite directions. A positive correlation would imply volatility increasing with rising prices, which contradicts the observed stress-period behavior.

  1. AStrongly negative correlationCorrect
  2. BStrongly positive correlation
  3. CZero correlation, since volatility is unobservable
  4. DCorrelation of exactly +1 because both are market variables

Explanation

Falling equity prices coincide with rising volatility, so returns and volatility changes move in opposite directions, which is negative correlation. Positive correlation would mean volatility rises with prices, the opposite of the observation.

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