Learning Outcomes: Explain how correlation contributed to the global financial crisis of 2007 to 2009.Explain the role of correlation risk in market, credit, systemic, and concentration risk.
Questions:
502.1. Your colleague Mary conveys to you that she has computed a Pearson correlation coefficient of 0.20 between two variables, but she is not yet specific about the variables. Each of the following statements must be true EXCEPT which is false?
a. As the correlation is non-zero, we can say there is a dependency between the variables; for example, we can say "the variables are dependent"
b. If the covariance does not change, an increase in the standard deviation (volatility) of one of the variables will decrease the correlation to a value below 0.20
c. If the correlation is a default correlation between a credit default swap (CDS) seller and the reference asset, the correlation must be monotonically increasing; i.e., the CDS spread is a continuously increasing function of a higher default correlation
d. If the correlation is between the returns of two assets in an equally-weighted portfolio, where each asset has the same daily standard deviation of 1.0%, the 10-day 99.0% value at risk (VaR) is about 5.70%
502.2. Meissner makes some important points about the terminology surrounding "correlation." Which of the following is true?
a. The term "correlation" is uniquely defined
b. Measures of association or measures of dependence refer to the linear Pearson correlation coefficient
c. Concentration risk has the same mathematical definition as correlation risk
d. In trading practice (e.g., correlation desks or correlation trading), the term correlation is defined broadly and can refer to any co-movement of assets over time
(Source: Gunter Meissner, Correlation Risk Modeling and Management, (New York: Wiley, 2014))
502.3. About the role of correlation in the global financial crisis (GFC), Meissner shows firstly that several different types of correlation can be measured. For example, correlation between mortgages that underly a collateralized debt obligation is different than correlation between CDO tranches.
According to Meissner, each of the following is TRUE about the role of correlation in the crisis, EXCEPT which is false?
a. The Guassian copula correlation model was widely used to value collateralized debt obligations (CDOs) but the trust in the Guassian copula was naive; for example, low default probabilities and default correlations (between CDO assets) were often assumed as model inputs
b. Due to an increase in the default correlation among mortgages in collateralized debt obligations (CDOs), ceteris paribus, equity tranche spreads increased
c. Correlations between the tranches of the CDOs increased during the crisis, and this had a devastating effect on the super-senior tranches
d. Credit default swaps (CDS) were used as speculative instruments in ways that did not disperse risk like we expect insurance contracts to disperse risk
(Source: Gunter Meissner, Correlation Risk Modeling and Management, (New York: Wiley, 2014))
Answers here:
Questions:
502.1. Your colleague Mary conveys to you that she has computed a Pearson correlation coefficient of 0.20 between two variables, but she is not yet specific about the variables. Each of the following statements must be true EXCEPT which is false?
a. As the correlation is non-zero, we can say there is a dependency between the variables; for example, we can say "the variables are dependent"
b. If the covariance does not change, an increase in the standard deviation (volatility) of one of the variables will decrease the correlation to a value below 0.20
c. If the correlation is a default correlation between a credit default swap (CDS) seller and the reference asset, the correlation must be monotonically increasing; i.e., the CDS spread is a continuously increasing function of a higher default correlation
d. If the correlation is between the returns of two assets in an equally-weighted portfolio, where each asset has the same daily standard deviation of 1.0%, the 10-day 99.0% value at risk (VaR) is about 5.70%
502.2. Meissner makes some important points about the terminology surrounding "correlation." Which of the following is true?
a. The term "correlation" is uniquely defined
b. Measures of association or measures of dependence refer to the linear Pearson correlation coefficient
c. Concentration risk has the same mathematical definition as correlation risk
d. In trading practice (e.g., correlation desks or correlation trading), the term correlation is defined broadly and can refer to any co-movement of assets over time
(Source: Gunter Meissner, Correlation Risk Modeling and Management, (New York: Wiley, 2014))
502.3. About the role of correlation in the global financial crisis (GFC), Meissner shows firstly that several different types of correlation can be measured. For example, correlation between mortgages that underly a collateralized debt obligation is different than correlation between CDO tranches.
According to Meissner, each of the following is TRUE about the role of correlation in the crisis, EXCEPT which is false?
a. The Guassian copula correlation model was widely used to value collateralized debt obligations (CDOs) but the trust in the Guassian copula was naive; for example, low default probabilities and default correlations (between CDO assets) were often assumed as model inputs
b. Due to an increase in the default correlation among mortgages in collateralized debt obligations (CDOs), ceteris paribus, equity tranche spreads increased
c. Correlations between the tranches of the CDOs increased during the crisis, and this had a devastating effect on the super-senior tranches
d. Credit default swaps (CDS) were used as speculative instruments in ways that did not disperse risk like we expect insurance contracts to disperse risk
(Source: Gunter Meissner, Correlation Risk Modeling and Management, (New York: Wiley, 2014))
Answers here:
