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FRM Part II · FRM Exam Part II · Global Financial Stability Report, April 2025, Chapter 2 (Geopolitical Risk)

A portfolio manager regresses monthly excess returns on an equity index against changes in the GPR index and finds a coefficient of -0.5% per 1 standard deviation rise in GPR. The GPR index then rises by 2.5 standard deviations while the unconditional expected excess return is +0.8% for the month. Assuming the relationship is linear and all else is equal, what is the conditional expected excess return?

The conditional expected excess return is minus 0.45 percent. The GPR effect is minus 0.5 percent times 2.5, or minus 1.25 percent, which is added to the unconditional expectation of plus 0.8 percent. Ignoring the baseline or flipping the sign gives the wrong results.

  1. A-0.45%Correct
  2. B-1.25%
  3. C+2.05%
  4. D+0.30%

Explanation

Impact = -0.5% x 2.5 = -1.25%. Conditional expected return = 0.8% - 1.25% = -0.45%. The -1.25% option omits the baseline; +2.05% uses the wrong sign; +0.30% applies only a one-standard-deviation effect (0.8 - 0.5).

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