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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 equity correlations over several decades and finds that when the average pairwise correlation is far above its long-run mean, it tends to drift back toward that mean over the following periods. Which description best fits this empirical property?

Equity correlations exhibit mean reversion: when they are unusually high or low relative to their long-run average, they tend to drift back toward it. They do not follow a random walk or stay constant, which is why the described pattern is mean reversion.

  1. ACorrelations follow a random walk with no tendency to return to a level
  2. BCorrelations exhibit mean reversion toward a long-run levelCorrect
  3. CCorrelations are constant across economic states
  4. DCorrelations always rise after a decline in volatility

Explanation

Empirical studies of correlation show that equity correlations revert toward a long-run mean rather than wandering without bound. A random walk would have no pull back to a level, so that option contradicts the observation. The other options describe behavior not supported by the evidence.

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