The Pearson Correlation Model – Work of the Devil?

Gunter Meissner

“Not one subject in the universe is unworthy of study”

– Karl Pearson 1857–1936

While by far the most applied correlation model in finance, the Pearson correlation model is – due to its simplicity and linearity – also the most heavily criticised: “Anything that relies on correlation is charlatanism” (Nassim Taleb) and “Instruments whose pricing requires the input of correlation … are accidents waiting to happen” (Paul Wilmott). In this chapter we address this contradiction and evaluate whether the Pearson correlation approach is rigorous and suitable for modelling associations in finance.

INTRODUCTION

The Pearson correlation model is by far the most prominent in finance. It is applied in risk measures such as VaR (value-at-risk), see Chapters 1, 10 and 12; ES (expected shortfall), see Chapter 16; ERM (enterprise risk management); and EVT (extreme value theory). The higher the Pearson correlation between the assets in the portfolio, the higher the risk measures, since high correlation implies a high probability of many assets declining jointly.

Pearson correlations also play a central role in investment analysis. In MPT (modern portfolio theory) a Pearson correlation

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