Skip to content

FRM Part II · FRM Exam Part II · Financial Correlation Modeling - Bottom-Up Approaches

A risk manager observes that estimated correlations between equity returns rise sharply and revert slowly after market shocks. Which feature of a stochastic correlation model best captures this behavior?

A mean-reverting stochastic process for correlation best captures this. It lets correlation spike after shocks and then drift back toward a long-run level at a reversion speed, matching the empirical clustering and slow decay, which constant, trending, or fixed-at-one correlations cannot reproduce.

  1. AA constant correlation parameter calibrated to long-run data
  2. BA mean-reverting process for correlation, with a positive reversion speed toward a long-run levelCorrect
  3. CA deterministic linear trend in correlation over time
  4. DA correlation fixed at one in all stressed states

Explanation

Empirical correlation is mean-reverting and clusters in stress. A mean-reverting stochastic process, such as an Ornstein-Uhlenbeck type with long-run level, lets correlation jump and decay. A constant or deterministic trend cannot produce this dynamic.

Did you get it right without looking?

One question tells you little. A timed set on Financial Correlation Modeling - Bottom-Up Approaches shows your real accuracy, how long you take and where you lose marks.

Practise Financial Correlation Modeling - Bottom-Up ApproachesFree diagnostic mock

More Financial Correlation Modeling - Bottom-Up Approaches questions