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

A risk manager at a bank notes that during the 2007-2009 crisis, correlations between default events of many corporate names rose sharply together with the rise in market volatility. Which term best describes the risk that correlations between assets change unexpectedly in a way that harms a position's value?

The risk is called correlation risk: the possibility that the co-movement between assets, or between default events, shifts unexpectedly and hurts the value of a position that depends on it, as happened with credit correlations in the 2007-2009 crisis.

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

Explanation

Financial correlation risk is the risk that correlations between assets or default events change adversely, altering the value of correlation-sensitive positions such as CDOs or basket options. Basis risk concerns hedge instruments diverging from the exposure, not co-movement among assets.

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