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FRM Part II · FRM Exam Part II · Empirical Properties of Correlation: How Do Correlations Behave in the Real World?

An analyst examines correlation between stock returns and government bond returns over several decades. Which conclusion best reflects the empirical behavior of this cross-asset correlation?

The stock-bond correlation is time-varying and can switch sign with the macro regime, such as inflation levels and monetary policy. Treating it as a constant positive, negative, or zero value ignores regime dependence and can mislead diversification and hedging decisions.

  1. AIt is constant and strongly positive in every regime
  2. BIt is constant and strongly negative in every regime
  3. CIt varies over time and can change sign depending on the macro regime, such as inflation and monetary policy conditionsCorrect
  4. DIt is exactly zero because equities and bonds are driven by unrelated factors

Explanation

Stock-bond correlation is not stable: it has been positive in high-inflation regimes and negative in periods when growth shocks dominate and bonds act as safe havens. Assuming constant sign or zero correlation ignores this regime dependence, which matters for diversification and hedging.

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