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

Two assets have monthly return standard deviations of 4% and 6%, and a covariance of 0.0012 (in decimal squared terms). What is their correlation coefficient, and what does it imply?

The correlation is 0.50, a moderate positive linear relationship. It equals covariance divided by the product of standard deviations: 0.0012 divided by (0.04 times 0.06, or 0.0024), which gives 0.50.

  1. A0.50, a moderate positive linear relationshipCorrect
  2. B0.05, an almost negligible relationship
  3. C0.20, a weak positive linear relationship
  4. D0.83, a strong positive linear relationship

Explanation

Correlation = covariance / (σ1σ2) = 0.0012 / (0.04 × 0.06) = 0.0012 / 0.0024 = 0.50. The 0.05 option divides by the wrong scale, and 0.20 and 0.83 do not follow from the data.

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