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

Empirical studies of correlation dynamics show that correlations exhibit which property over time?

Correlations exhibit mean reversion toward a long-run level. Empirical evidence shows they fluctuate and tend to revert, which supports modelling correlation with mean-reverting processes rather than assuming it is constant or a random walk.

  1. AMean reversion toward a long-run levelCorrect
  2. BA pure random walk with no tendency to revert
  3. CPerfect stability
  4. DA deterministic upward trend

Explanation

Empirical evidence indicates correlations are mean reverting, which is why models such as mean-reverting stochastic processes are used for them. A random walk would be unbounded and correlations are bounded between -1 and 1. They are not stable or trending.

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