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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 equity correlations find that mean reversion in correlation is observed alongside which other feature, important for risk managers building stress scenarios?

Equity correlations tend to rise in volatile or falling markets while still reverting toward a long-run mean. Diversification therefore weakens during stress, so stress scenarios should use higher correlations than average.

  1. ACorrelations tend to rise in volatile or down markets, so diversification weakens when needed mostCorrect
  2. BCorrelations are constant across market regimes, so a single estimate suffices
  3. CCorrelations in equity markets are always negative during crises
  4. DCorrelations are unrelated to the level of market volatility

Explanation

Empirical evidence shows equity correlation is higher in recessions and market stress, and also reverts toward a mean over time. Constant correlation contradicts the evidence, and crisis correlations are typically positive and high, not negative.

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