FRM Part II · FRM Exam Part II · Empirical Properties of Correlation: How Do Correlations Behave in the Real World?
A risk manager reviews bond correlations and wants to apply the empirical evidence on credit spread correlations. Which conclusion is best supported?
Credit spread and default correlations tend to rise in recessions and credit stress, because common macroeconomic factors drive defaults across firms. This reduces diversification in credit portfolios precisely in downturns, and contradicts claims of cycle independence or falling correlations.
- ADefault-related correlations among corporate bond spreads tend to increase in recessions and credit stressCorrect
- BCorporate bond spread correlations fall sharply during recessions
- CDefault correlations are independent of the business cycle
- DInvestment-grade and speculative-grade spreads are always uncorrelated
Explanation
Empirically, default and credit spread correlations rise when the economy weakens, because common macro factors drive defaults. Falling or cycle-independent correlations contradict that. Investment-grade and speculative-grade spreads are positively related, especially in stress.
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