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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 monthly correlation between two equity indices over 20 years and finds that when the correlation is far above its long-run average, it tends to decline over the next period, and when it is far below, it tends to rise. Which statistical property of correlation does this describe?

The behavior is mean reversion. Correlation that sits well above or below its long-run average tends to move back toward that average, unlike a random walk, which has no pull toward a mean.

  1. AMean reversionCorrect
  2. BRandom walk with drift
  3. CPerfect persistence (unit root)
  4. DVolatility clustering in returns only

Explanation

Correlations pulled back toward a long-run average after deviating show mean reversion. A random walk or unit root would imply no tendency to return to a mean. Volatility clustering concerns return variance, not the reversion of correlation.

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