FRM Part II · FRM Exam Part II · Correlation Basics: Definitions, Applications, and Terminology
Two assets have monthly returns with covariance 0.0018. Asset A has a standard deviation of 6% and Asset B has a standard deviation of 5%. What is the Pearson correlation coefficient?
The correlation is 0.60. Divide the covariance of 0.0018 by the product of the standard deviations, 0.06 times 0.05, which equals 0.003. The result lies within the valid range of minus one to plus one.
- A0.30
- B0.60Correct
- C0.06
- D1.20
Explanation
Correlation = covariance / (σA σB) = 0.0018 / (0.06 × 0.05) = 0.0018 / 0.003 = 0.60. Using 0.30 would come from dividing by 0.006 (wrong product). 1.20 is impossible as correlation cannot exceed 1.
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