FRM Part II · FRM Exam Part II · Empirical Properties of Correlation: How Do Correlations Behave in the Real World?

A risk manager at a multi-asset fund notes that the equity-bond return correlation estimated over a calm five-year window is -0.30, but during the most recent market sell-off the realized correlation turned strongly positive. Which conclusion is most consistent with the empirical evidence on correlation behavior?

Correlations are unstable and can change regime during stress, so a calm-period equity-bond estimate can overstate the diversification benefit. Empirical evidence shows correlations vary over time and can move sharply, though not always to exactly +1, so risk models need stress-sensitive correlation assumptions.

1. ACorrelations are constant over time, so the sell-off reading is sampling noise and should be ignored
2. BCorrelations are unstable and can shift regime during stress, so a single historical estimate can overstate diversification benefitsCorrect
3. CCorrelations between asset classes always converge to exactly +1 in a sell-off
4. DCorrelation instability only affects fixed income portfolios and not equity portfolios