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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 wants a correlation input for stress testing that reflects the empirical tendency of correlations to rise in crises. Which approach is most appropriate?

Use a stressed correlation matrix calibrated to crisis-period data alongside the baseline estimate. Since correlations tend to rise in crises, low or average correlations understate stressed losses, and assuming zero correlation ignores co-movement altogether.

  1. AUse the lowest historical correlation observed to be conservative
  2. BUse the long-run average correlation, since correlations mean-revert
  3. CUse a stressed correlation matrix calibrated to crisis-period observations, alongside the baseline estimateCorrect
  4. DSet all correlations to zero to isolate idiosyncratic risk

Explanation

Because correlations tend to rise in crises, stress tests should use crisis-calibrated or stressed matrices. The lowest or average correlation understates stress diversification loss, and zero correlation ignores co-movement.

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