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FRM Part II · FRM Exam Part II · The Financial Stability Implications of Artificial Intelligence

A bank's market risk team observes that after several dealers adopted similar AI-based hedging tools, asset correlations rise sharply during sell-offs. Which implication is most appropriate for the bank's risk framework?

The bank should stress-test with higher, stress-dependent correlations and crowded-trade scenarios. Similar AI tools make behavior converge, so correlations spike in sell-offs and historical averages overstate diversification. Changing VaR confidence does not fix the underlying understatement of correlated risk.

  1. ARely on historical average correlations because AI tools stabilize relationships
  2. BStress-test using higher, regime-dependent correlations and consider crowded-trade scenariosCorrect
  3. CReduce VaR confidence level to offset the correlation increase
  4. DAssume diversification benefits are unchanged because positions are hedged

Explanation

Herding from common tools makes correlations rise in stress, so average historical correlations understate risk. Stress tests with elevated correlations and crowded-trade scenarios capture this. Changing the confidence level does not address the correlation shift.

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