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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 team finds that estimated correlations between two assets rise substantially in market downturns relative to upturns, and that this pattern persists over many years. Which conclusion is most consistent with the empirical evidence?

Correlations tend to be higher in stressed markets and recessions, so using one constant correlation estimated in calm periods understates portfolio risk in downturns, when diversification benefits are weakest.

  1. ACorrelation is independent of market conditions
  2. BCorrelation tends to be higher in recessions or stressed markets, so a single constant correlation understates risk in downturnsCorrect
  3. CCorrelation is lower in stress, improving diversification
  4. DCorrelation is symmetric across up and down markets

Explanation

Empirical studies find correlations rise in recessions and market stress, and the effect is asymmetric. A constant correlation calibrated on calm periods therefore understates joint losses in downturns. The other options contradict this finding.

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