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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 equity correlations are mean reverting and are historically higher in recessions than in expansions. For a one-year horizon stress test starting from a very low current correlation, which implication of mean reversion is most appropriate?

Under mean reversion, a very low correlation is expected to drift upward toward its long-run average, so the diversification benefit assumed today may erode over the horizon. The convergence is gradual and not exact, so stress tests should allow for higher correlations.

  1. AExpect correlation to stay at its low level since it is unrelated to past values
  2. BExpect correlation to be pulled upward toward its long-run mean, so diversification benefit may erodeCorrect
  3. CExpect correlation to fall further because low values persist indefinitely
  4. DExpect correlation to become exactly equal to the long-run mean within one year

Explanation

Mean reversion implies a low correlation will tend to rise toward its long-run level, reducing diversification benefits, which matters for stress tests. Persistence forever or independence from past values contradicts mean reversion, and exact convergence within a year is not implied since the gap decays gradually.

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