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FRM Part II · FRM Exam Part II · Correlation Basics: Definitions, Applications, and Terminology

A risk manager notes that correlations between two commodity prices have been about 0.6 on average, but over the past year they fluctuated from 0.2 to 0.9 and tended to drift back toward 0.6 after large deviations. Which term best describes this tendency?

The behavior is correlation mean reversion: correlations deviate from their long-run average of about 0.6 but tend to return toward it over time. It differs from correlation skew, which depends on market direction, and from correlation breakdown, where a relationship fails.

  1. ACorrelation mean reversionCorrect
  2. BCorrelation skew
  3. CCorrelation clustering
  4. DCorrelation breakdown

Explanation

Drifting back toward a long-run average after deviations is mean reversion. Skew concerns dependence on market direction, and breakdown refers to relationships that fail, for example under a structural change.

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