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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 reviews empirical evidence on how equity correlations behave across the economic cycle. Which statement is most consistent with the findings in Hull-style/Jorion-style empirical studies of correlation (Mean reversion, business-cycle and regime effects)?

Equity correlations tend to be higher in recessions than in expansions. During downturns and crises, assets move together more strongly, so diversification benefits shrink exactly when investors need them, and portfolio risk estimated with calm-period correlations is understated.

  1. AEquity correlations tend to be higher in recessions than in expansionsCorrect
  2. BEquity correlations tend to be higher in expansions than in recessions
  3. CEquity correlations are constant across the economic cycle
  4. DEquity correlations are unrelated to volatility levels

Explanation

Empirical evidence (Meissner) shows equity correlations are higher in recessions and crises than in expansions, which reduces diversification benefits when it is most needed. Stating that expansions have higher correlation reverses the finding.

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