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

Empirical research on correlation finds that equity correlations show a specific pattern relative to market direction. Which is best supported?

Equity correlations are higher in down markets than in up markets. This asymmetry means diversification weakens during sell-offs, so risk models that assume constant correlation understate portfolio losses in stress.

  1. ACorrelations are higher in down markets than in up marketsCorrect
  2. BCorrelations are higher in up markets than in down markets
  3. CCorrelations are identical in up and down markets
  4. DCorrelations are zero in extreme markets

Explanation

Empirical studies show asymmetric correlation: equity correlations are higher when markets fall than when they rise. Equal correlations would imply no asymmetry, which is contradicted by the evidence. Zero correlation in extremes is not supported.

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