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FRM Part II · FRM Exam Part II · Empirical Properties of Correlation: How Do Correlations Behave in the Real World?

A bank's risk team estimates portfolio VaR using correlations measured during a calm period. Empirical research suggests correlations rise in market stress. What is the most likely consequence for the bank's VaR?

VaR will be understated in a crisis. Calm-period correlations are lower than stress correlations, so the model overstates diversification benefits. When correlations rise, actual portfolio risk exceeds the estimate, which is why stress testing with elevated correlations is recommended.

  1. AVaR will be overstated in a crisis
  2. BVaR will be understated in a crisis because diversification benefits are overestimatedCorrect
  3. CVaR is unaffected because VaR depends only on volatility
  4. DVaR will be exactly correct because correlations are stable

Explanation

Higher correlation in stress reduces diversification, raising true portfolio risk above the calm-period estimate. The bank therefore underestimates VaR. VaR depends on both volatilities and correlations, so the third option is wrong.

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