Skip to content

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

Empirical research on equity correlations finds that correlations tend to be higher in which market condition, and what is the implication for a VaR model that uses a full-sample average correlation?

Equity correlations tend to be higher in recessions and down markets. A VaR model using a full-sample average correlation therefore understates co-movement during downturns, so portfolio risk may be underestimated precisely when losses are largest and diversification is needed most.

  1. AHigher in strong up markets; VaR is overstated in downturns
  2. BHigher in recessions or down markets; VaR may be understated when it matters mostCorrect
  3. CUnrelated to market direction; the full-sample average is unbiased in all regimes
  4. DLower in recessions; VaR is overstated in downturns

Explanation

Equity correlations are typically higher in recessions and down markets than in expansions or up markets. A full-sample average blends calm and stress regimes, so it understates co-movement in downturns and thus understates stress VaR.

Did you get it right without looking?

One question tells you little. A timed set on Empirical Properties of Correlation: How Do Correlations Behave in the Real World? shows your real accuracy, how long you take and where you lose marks.

Practise Empirical Properties of Correlation: How Do Correlations Behave in the Real World?Free diagnostic mock

More Empirical Properties of Correlation: How Do Correlations Behave in the Real World? questions