FRM Part II · FRM Exam Part II · Correlation Basics: Definitions, Applications, and Terminology
Two assets have returns with standard deviations of 10% and 20% and a covariance of 0.009. What is the correlation coefficient between them?
The correlation is 0.45. It equals covariance divided by the product of the two standard deviations: 0.009 divided by (0.10 times 0.20), which is 0.009 divided by 0.02. Correlation is a standardized covariance bounded between -1 and +1.
- A0.045
- B0.45Correct
- C0.90
- D0.18
Explanation
Correlation = covariance / (σ1 × σ2) = 0.009 / (0.10 × 0.20) = 0.009 / 0.02 = 0.45. Choosing 0.90 results from dividing by only the product 0.01 (mistaken base), and 0.045 from dividing by 0.2 only.
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