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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 the empirical behavior of equity correlations across many stock pairs over a long sample. Which finding is most consistent with the evidence in the empirical correlation literature (Hull-style reading)?

Equity correlations exhibit mean reversion: they fluctuate over time but tend to be pulled back toward a long-run average. They are neither constant nor a random walk, and they typically rise rather than turn negative in crises.

  1. AEquity correlations are constant over time and unrelated to market conditions
  2. BEquity correlations show mean reversion toward a long-run levelCorrect
  3. CEquity correlations follow a random walk with no tendency to revert
  4. DEquity correlations are always negative during market crises

Explanation

Empirical studies of correlation find that correlations fluctuate but are pulled back toward a long-run average, i.e. mean reverting. Constant correlation and random walk behavior are contradicted by the data. Crises tend to raise correlations, not make them negative.

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