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FRM Part II · FRM Exam Part II · Correlation Basics: Definitions, Applications, and Terminology

A bank's risk team observes that during market stress, correlations among equity returns rise sharply compared with calm periods. Which implication for a VaR model that uses calm-period correlations is most accurate?

The model overstates diversification and underestimates VaR in stress. When correlations rise in crises, assets move together more, so portfolio losses are larger than predicted using the lower calm-period correlations, making the calm-calibrated VaR too low.

  1. AIt overstates diversification benefit and underestimates portfolio VaR in stressCorrect
  2. BIt understates diversification benefit and overestimates portfolio VaR in stress
  3. CIt has no effect because VaR depends only on volatilities
  4. DIt affects only the expected return, not risk

Explanation

Higher correlation reduces diversification, so portfolio risk is greater than a model with low correlations implies. Using calm-period correlations therefore underestimates stress VaR. Choice two reverses the direction of the effect, and volatilities alone do not determine portfolio VaR.

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