Skip to content

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

A risk team compares the empirical behavior of default correlation and equity correlation. Which statement is consistent with the evidence discussed for correlation in credit markets?

Default correlations tend to rise in recessions and when credit conditions deteriorate. Common macroeconomic factors push defaults to cluster in downturns, so models assuming constant default correlation understate portfolio credit losses during stress.

  1. ADefault correlations tend to increase in recessions and when credit conditions worsenCorrect
  2. BDefault correlations are lower in recessions than in expansions
  3. CDefault correlations are independent of the economic cycle
  4. DDefault correlations are always zero for investment-grade firms

Explanation

Empirically, default correlation is higher in recessions and periods of stress, since firms are affected by common macro factors. This parallels equity correlation behavior. Stating that it falls or is cyclical-independent contradicts the evidence.

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