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

Over a long sample, a risk manager observes that the correlation between two stock returns is mean-reverting. Following a month in which the correlation spiked far above its long-run average, what does mean reversion imply for the expected correlation next period?

Expected correlation will move back toward its long-run average. Mean reversion means that unusually high or low correlations tend to be gradually pulled toward the long-run level, rather than continuing to rise, vanishing to zero, or staying elevated permanently.

  1. AIt will rise further because of momentum
  2. BIt will move toward the long-run averageCorrect
  3. CIt will fall to exactly zero
  4. DIt will remain at the spike level permanently

Explanation

Mean reversion means deviations from the long-run level tend to be pulled back toward it, though not instantly or exactly. Momentum, permanence and zero are inconsistent with this property.

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