What are some of the drawbacks of correlation estimates? Which of the following statements identifies major problems with correlation calculations?

What are some of the drawbacks of correlation estimates? Which of the following statements identifies major problems with correlation calculations?

I. Correlation estimates are not able to capture increases in factor co-movements in extreme market scenarios.

II. Correlation estimates tend to be unstable.

III. Historical correlations may not forecast future correlations correctly.

IV. Correlation estimates assume normally distributed returns.
A . I and II
B . I and IV
C . I, II and III
D . II, III, and IV

View Answer

Answer: C

Explanation:

Major problems with correlation calculations include:

I. Correlation estimates are not able to capture increases in factor co-movements in extreme market scenarios, as correlations can change significantly during periods of market stress.

II. Correlation estimates tend to be unstable, meaning they can vary widely over time and in different market conditions.

III. Historical correlations may not forecast future correlations correctly, as past data may not always be indicative of future relationships.

IV is incorrect because correlation estimates do not inherently assume normally distributed returns, though the assumption of normality is often used in conjunction with correlation calculations.