FRM Part II · FRM Exam Part II · Correlation Basics: Definitions, Applications, and Terminology
Over a long sample, the monthly correlation between two asset returns fluctuates but is observed to drift back toward a long-run average of about 0.40 after temporary spikes to 0.80 or dips to 0.05. Which property is being described?
This is correlation mean reversion. Correlation deviates temporarily from its long-run average, here about 0.40, but is pulled back toward it over time. It contrasts with a persistent trend and is often modeled with autoregressive processes.
- ACorrelation mean reversionCorrect
- BCorrelation stationarity failure
- CCorrelation convexity
- DCorrelation skew
Explanation
Mean reversion means that correlation is pulled back toward a long-run level after deviations. Because the series returns to a stable average, it does not show a persistent trend. Skew and convexity are not the terms for this behavior.
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