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FRM Part II · FRM Exam Part II · Portfolio Risk: Analytical Methods

A bank's parametric VaR relies on a correlation matrix estimated from a calm two-year period. In a market crisis, correlations among the bank's equity and credit positions rise sharply toward one. What is the most likely consequence, and the most appropriate response?

VaR is understated because the calm-period correlations credited diversification that disappears when correlations spike toward one. The appropriate response is to supplement VaR with stress tests that impose crisis-level correlations, rather than relying on historically estimated relationships alone.

  1. AVaR is overstated; the bank should reduce its confidence level
  2. BVaR is unaffected, because correlations only influence expected return
  3. CVaR is understated because diversification benefits vanish; the bank should supplement VaR with stress tests using higher correlationsCorrect
  4. DVaR is understated only for single-asset portfolios; no action is needed for diversified portfolios

Explanation

Parametric VaR credits diversification via low estimated correlations. When correlations rise toward one, diversification disappears and actual risk exceeds the calm-period VaR. Stress scenarios that impose crisis correlations address this weakness.

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