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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 wants a model that reflects the empirical tendency of correlation to move over time and to revert toward a long-run level. Which approach is most appropriate?

A mean-reverting stochastic correlation model with a long-run mean, complemented by stress scenarios using elevated correlations, best fits the evidence. Empirically, correlations vary through time and revert toward a long-run level, so constant, zero or minimum-based assumptions would understate risk.

  1. AUse a mean-reverting stochastic correlation model, such as an autoregressive process with a long-run mean, alongside stress scenarios with elevated correlationCorrect
  2. BFix correlation at its historical minimum to be conservative
  3. CAssume correlation equals zero to reflect diversification
  4. DUse a single constant correlation estimated over the full history

Explanation

Empirically correlations show mean reversion and time variation, so a model with a long-run mean and stochastic dynamics fits better, supplemented by stress scenarios with high correlation. Using the historical minimum or zero would understate risk, and a constant ignores variation.

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