THE DEPENDENCE STRUCTURE BETWEEN THE RETURNS OF FINANCIAL ASSETS P...

14.

The dependence structure between the returns of financial assets plays an important role in risk measure-

ment. For liquid markets, which of the following statements is incorrect?

a.

Correlation is a valid measure of dependence between random variables for only certain types of return

distributions.

b.

Even if the return distributions of two assets have a correlation of zero, the returns of these assets are not

necessarily independent.

c.

Copulas make it possible to model marginal distributions and the dependence structure separately.

d.

With short time horizons (3 months or less), correlation estimates are typically very stable.

Correct Answer: d

Rationale:

Correlation estimates tend to be very volatile when short term time horizons are considered.

Section: Market Risk Measurement and Management

Reference:

Kevin Dowd (2005), Measuring Market Risk, 2nd Edition, Chapter 5, Appendix: “Modeling Dependence:

Correlations and Copulas.”

Learning Objective:

Explain the drawbacks of using correlation to measure dependence. Describe how copulas pro-

vide an alternative measure of dependence.

Reference:

Gunter Meissner, Correlation Risk Modeling and Management, Chapter 1, “Some Correlation Basics:

Properties, Motivation, Terminology.”

Learning Objective:

Describe financial correlation risk and the areas in which it appears in finance.

2015 Financial Risk Manager (FRM®) Practice Exam