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FRM Part II · FRM Exam Part II · Correlation Basics: Definitions, Applications, and Terminology

Over a long sample, an analyst finds that the correlation between two equity indices is 0.45 in calm markets, but rises to 0.80 when both indices fall by more than two standard deviations. This pattern is best described as:

This is correlation skew: correlations are higher in down markets than in up or calm markets. It matters because diversification benefits shrink exactly when losses are large. Mean reversion refers to correlations drifting toward a long-run average over time, which is a different property.

  1. ACorrelation breakdown that shows diversification improves in crises
  2. BMean reversion of correlation toward a long-run level
  3. CCorrelation skew, with higher correlation in down markets than in up marketsCorrect
  4. DSpurious correlation caused by a common trend

Explanation

Correlation that is higher in sharp downturns than in rising or calm markets is called correlation skew. Mean reversion describes drift back to a long-run mean over time, not dependence on market direction. Diversification worsens here, not improves.

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