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FRM Part I · FRM Exam Part I · Stress Testing

A bank's stress test applies a severe equity market fall but assumes that correlations between asset classes stay at their long-run averages. During a real crisis, correlations across risky assets rise sharply toward one. What is the most direct implication for the stress test results?

Losses are likely understated. Assuming long-run correlations gives credit for diversification that vanishes in a crisis, when risky assets fall together as correlations approach one. The actual aggregate loss therefore exceeds the stress test estimate.

  1. ALosses are likely understated because diversification benefits are overestimatedCorrect
  2. BLosses are likely overstated because correlation increases reduce volatility
  3. CResults are unaffected because correlations do not influence portfolio losses under large shocks
  4. DLosses are likely understated only for risk-free assets

Explanation

Stable-correlation assumptions credit the portfolio with diversification that disappears in crises. When correlations rise toward one, losses across positions occur together, so portfolio losses exceed those estimated. Correlations clearly matter for aggregate loss.

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