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FRM Part I · FRM Exam Part I · Enterprise Risk Management and Future Trends

A firm's ERM program aggregates risks using a bottom-up approach and finds that, in a severe stress, correlations between credit and market losses rise sharply compared with normal conditions. Which implication is MOST appropriate for the ERM framework?

Normal-time correlations would overstate diversification benefits, because correlations rise in stress. The ERM framework should supplement aggregation with stressed correlations and scenario analysis rather than reducing capital or abandoning enterprise-wide aggregation.

  1. ADiversification benefits computed under normal-time correlations may be overstated, so stressed correlations and scenario analysis should supplement the aggregationCorrect
  2. BDiversification benefits are understated, so firm-wide capital can be reduced
  3. CCorrelations are irrelevant to enterprise-wide aggregation because capital is additive
  4. DThe firm should stop aggregating risks and revert to managing each risk type independently

Explanation

When correlations rise in stress, true diversification is lower than estimated using normal-time correlations, so capital could be inadequate. ERM should therefore use stressed correlations and scenarios. Reducing capital would worsen the problem, and abandoning aggregation loses the integrated view.

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