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FRM Part II · FRM Exam Part II · Advances in Artificial Intelligence: Implications for Capital Markets Activities

A market-making desk at a mid-sized dealer deploys a machine learning model to adjust bid-ask quotes in real time based on order flow, inventory and volatility signals. Which risk is most directly heightened if many dealers adopt similar models trained on similar data?

The key risk is correlated behaviour. If many dealers use similar AI models and data, they may widen quotes, hedge or withdraw liquidity at the same time in stress, which amplifies market moves and weakens the liquidity that market making is meant to supply.

  1. AReduced model complexity leading to underfitting across all dealers
  2. BCorrelated quoting and hedging behaviour that can amplify market stress and withdraw liquidity simultaneouslyCorrect
  3. CLower operational risk because quoting decisions are fully automated
  4. DElimination of inventory risk because the model neutralises positions

Explanation

Similar models and data can make dealers react the same way to the same signals, widening spreads or pulling quotes together in stress. This herding amplifies shocks. Automation does not remove operational risk, and models do not eliminate inventory risk.

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