FRM Part II · FRM Exam Part II · Portfolio Construction
A leveraged risk-parity fund holds stocks and bonds sized to equal risk contributions, using borrowing to reach a target volatility. Which scenario poses the greatest threat to this strategy?
The greatest threat is rising rates combined with falling equities, where stock-bond correlation turns positive and volatility jumps. Diversification fails, leveraged bond positions lose, and volatility-targeting forces deleveraging, so losses compound.
- AA sustained period of low inflation with stable correlations
- BA simultaneous rise in interest rates and falling equity prices, with rising stock-bond correlation and higher volatilityCorrect
- CA fall in the volatility of all asset classes together
- DA steady decline in short-term financing costs
Explanation
The strategy relies on bonds diversifying equities and on stable volatility estimates. Rising rates hurt leveraged bonds while equities fall, and higher volatility forces deleveraging, amplifying losses. The other scenarios are benign or helpful.
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