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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 findings on correlation behavior compares equity correlations across market regimes. Which observation is most consistent with the empirical evidence on equity correlations?

Equity correlations tend to be higher in recessions than in expansions. In stressed, high-volatility markets stocks move together more strongly, so diversification benefits shrink exactly when they are needed. Constant correlations or lower downturn correlations are not supported by empirical evidence.

  1. AEquity correlations tend to be higher in recessions than in expansionsCorrect
  2. BEquity correlations are constant over time and unaffected by the economic cycle
  3. CEquity correlations tend to be lower in market downturns than in booms
  4. DEquity correlations are negatively related to equity volatility

Explanation

Empirical evidence shows equity correlations rise in recessions and in periods of high volatility, when stocks tend to move together. Constant or lower correlation in downturns contradicts the evidence. Correlation and volatility are positively, not negatively, related.

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