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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 manager notes that correlations between bond yield changes at different maturities on a government curve have been estimated over many years. Which pattern is most consistent with empirical findings on term structure correlations?

Correlations between yield changes at adjacent maturities are high and decline as the gap between maturities widens, usually staying positive. Neighboring points share the same drivers, whereas distant points are influenced partly by different factors, such as policy expectations versus term premia.

  1. ACorrelations between adjacent maturities are high and decline as the maturity gap widensCorrect
  2. BCorrelations between adjacent maturities are low and increase as the maturity gap widens
  3. CCorrelations are identical across all pairs of maturities
  4. DCorrelations between short and long maturities are always negative

Explanation

Yield changes on neighboring maturities are driven by common factors, so correlation is high, and it declines as maturity separation increases, though it generally stays positive. The reverse pattern and the identical-correlation claim do not fit the data, which is why a few principal components capture most curve variance.

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