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FRM Part II · FRM Exam Part II · Global Financial Stability Report, April 2025, Chapter 2 (Geopolitical Risk)

A bank's chief risk officer must decide how to reflect heightened geopolitical risk in the investment portfolio. Equity portfolio VaR rises when correlations among holdings increase in stress. Which action best reflects the risk-management lesson that geopolitical shocks can raise cross-asset co-movement and reduce diversification?

The bank should apply stressed correlation assumptions and set concentration limits by country and sector alongside standard VaR. Geopolitical shocks can increase co-movement across assets and erode diversification, so long-run average correlations and added leverage would understate and magnify risk.

  1. AUse stressed correlation assumptions and concentration limits by country and sector, in addition to standard VaRCorrect
  2. BRely on the long-run average correlation matrix because it is statistically stable
  3. CIncrease leverage on diversified positions since diversification lowers risk
  4. DRemove all hedges to reduce basis risk during periods of high uncertainty

Explanation

Geopolitical shocks can raise correlations and weaken diversification, so stress correlations and exposure limits by country and sector complement standard VaR. A long-run average matrix understates stress dependence. More leverage relies on diversification that may fail, and removing hedges leaves the portfolio exposed.

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