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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 studies monthly changes in the correlation between two equity indices over 20 years. The correlation series fluctuates but tends to drift back toward its long-run average of 0.45 after unusually high or low readings. Which statement best describes this empirical property?

The behavior is mean reversion. After correlation moves well above or below its long-run average, it tends to drift back toward that level over time, unlike a random walk, which has no long-run anchor, or a constant correlation, which would not fluctuate.

  1. ACorrelation exhibits mean reversionCorrect
  2. BCorrelation is constant over time
  3. CCorrelation follows a random walk with no long-run level
  4. DCorrelation is always positively related to volatility only in bond markets

Explanation

Empirical studies of correlation (Hull-type analysis in the reading) show that correlations tend to revert toward a long-run mean rather than wander without bound. A series that returns to its average after deviations is mean reverting. A random walk would have no pull toward a long-run level.

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