FRM Part I · FRM Exam Part I · Stress Testing
A bank stress tests its trading book using a scenario in which equity prices fall 30%. The model keeps the historical correlation between equity returns and credit spreads fixed, even though in past crises correlations rose sharply. Which model challenge does this most directly represent?
The challenge is correlation instability. Fixing correlations at historical, normal-period levels ignores that dependence tends to rise in crises, so diversification benefits are overstated and the stressed loss is understated.
- AIgnoring the instability of correlations under stress, so the diversification benefit is overstatedCorrect
- BUsing too long a time horizon for the liquidity adjustment
- CDouble counting of risk factors across business lines
- DOver-reliance on the normal distribution for the scenario's probability
Explanation
Holding correlations at normal-period values assumes stable dependence. In crises correlations typically rise, reducing diversification, so losses are understated. The other options describe different issues that are not described in the scenario.
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