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FRM Part II · FRM Exam Part II · Empirical Properties of Correlation: How Do Correlations Behave in the Real World?

Which of the following best describes the empirical behavior of correlations observed in studies of different economic states and volatility regimes?

Correlations mean-revert toward a long-run level and are higher during recessions and high-volatility periods. They are neither constant nor a random walk. This behavior means diversification weakens in stressed states, which models with constant correlation fail to capture.

  1. ACorrelations exhibit mean reversion and are higher in recessions and high-volatility periodsCorrect
  2. BCorrelations follow a random walk with no tendency to return to a long-run level
  3. CCorrelations are constant over time across economic states
  4. DCorrelations are lowest in recessions because asset prices diverge

Explanation

Empirical work finds correlations mean-revert toward a long-run average and are higher in recessions and volatile periods. A random walk or constant correlation assumption contradicts the evidence. Lower correlation in recessions is the opposite of what is observed.

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