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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 studying Hull's empirical evidence on correlations across asset classes compares equity, bond and commodity markets. Which observation is most consistent with the empirical findings on how correlations behave in equity markets during stress?

Equity correlations tend to rise during sharp market downturns. Because stocks then move together more strongly, diversification benefits shrink exactly when investors need them most. This asymmetry is a well-documented empirical feature, contradicting claims that correlations are constant, falling, or negative in stress.

  1. AEquity correlations tend to rise in sharp market downturns, reducing diversification benefits when they are most neededCorrect
  2. BEquity correlations tend to fall in sharp market downturns, increasing diversification benefits
  3. CEquity correlations are constant over time and unaffected by market conditions
  4. DEquity correlations are consistently negative between large-cap stocks in the same market

Explanation

Empirical evidence shows equity correlations increase in down markets and in crises. This weakens diversification precisely when losses occur. The options claiming falling, constant, or negative correlations contradict the observed evidence.

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