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FRM Part I · FRM Exam Part I · Learning From Financial Disasters

A hedge fund held highly leveraged positions that were hedged against small price movements by models. When markets moved abnormally and liquidity vanished, the fund suffered large losses and required a rescue. Which lesson is most consistent with this type of disaster?

The key lesson is that models calibrated to normal historical conditions can break down in extreme markets, especially when leverage is high and liquidity disappears. Firms should stress test leverage, liquidity and correlation assumptions instead of trusting low modeled volatility or apparent diversification across similar trades.

  1. AModels calibrated to normal historical conditions can fail in extreme markets, so leverage and liquidity risk must be stress testedCorrect
  2. BHigh leverage is safe provided the model shows low volatility
  3. CDiversification across correlated convergence trades eliminates liquidity risk
  4. DRescue by creditors proves the firm's risk management was effective

Explanation

Highly leveraged funds relying on models based on historical relationships are vulnerable when correlations shift and liquidity dries up. Stress testing leverage and liquidity is the lesson. Low modeled volatility does not make leverage safe, and apparent diversification across similar trades disappears in stress.

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