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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 equity index correlations over a long history and notes that the average pairwise correlation is much higher during recessions than during expansions. Which conclusion is most consistent with the empirical evidence discussed by Hull and others on correlation behavior?

Correlations tend to be higher in recessions, so a VaR model calibrated to expansion-period correlations would overstate diversification and understate downturn risk. Empirical evidence shows correlations rise in stressed markets, which is why using a calm-period estimate for stress conditions is dangerous.

  1. ACorrelations are constant across the economic cycle, so a single long-run estimate is adequate for VaR
  2. BCorrelations tend to be higher in recessions, so a VaR model using an expansion-period correlation would likely understate portfolio risk in a downturnCorrect
  3. CCorrelations tend to be lower in recessions, so diversification benefits increase when markets fall
  4. DCorrelations depend only on the choice of sampling frequency and not on the economic state

Explanation

Empirical studies show equity correlations rise in recessions and in stressed markets. A VaR model calibrated to calm-period correlations therefore overstates diversification benefits and understates loss in a downturn. The option claiming lower correlations in recessions reverses the evidence.

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