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FRM Part II · FRM Exam Part II · Correlation Basics: Definitions, Applications, and Terminology

A risk analyst reviews a portfolio and notes that the correlation between two asset returns rises sharply during market crashes, while remaining low in calm periods. Which term best describes the risk that the correlation between assets changes adversely, as discussed in the financial correlation literature?

The risk is called correlation risk: the possibility of loss because correlations between assets or risk factors move adversely, for example rising sharply in a crash. It differs from basis, gamma and settlement risk, which concern hedge mismatch, option delta convexity and payment failure respectively.

  1. ACorrelation riskCorrect
  2. BBasis risk
  3. CGamma risk
  4. DSettlement risk

Explanation

Financial correlation risk is the risk of loss from adverse changes in correlations between financial variables. Observed crash-time correlation spikes are an example. Basis risk concerns hedge instrument mismatch, gamma risk concerns option delta changes, and settlement risk concerns payment failure.

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