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

An analyst observes that two stocks have a Pearson correlation of 0.60 between their daily returns. Which statement about interpreting this figure is most accurate?

Pearson correlation measures only the strength of linear dependence, so a value of 0.60 can miss nonlinear relationships and tail dependence. It does not measure causation, a regression slope, or the percentage of days with matching direction, which are common misinterpretations.

  1. AIt captures the strength of linear dependence and may understate dependence that is nonlinear or concentrated in the tailsCorrect
  2. BIt proves that a 1% rise in one stock causes a 0.6% rise in the other
  3. CIt implies that the two stocks are independent in the extreme tails of their return distributions
  4. DIt means 60% of the days both stocks moved in the same direction

Explanation

Pearson correlation measures linear association only; it is not a causal elasticity, not a frequency of same-direction days, and says little about tail dependence. Two variables can have a moderate correlation yet exhibit strong joint extremes. The elasticity reading confuses correlation with a regression beta.

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