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, the correlations between many asset returns rose sharply while markets fell. Which term best describes the risk that the correlations used in a pricing or hedging model differ from those that actually materialize?
The risk that correlations used in models differ from, or move unfavorably relative to, realized correlations is called financial correlation risk. It matters in crises when correlations jump. Basis, default intensity and liquidity risks are separate concepts with different drivers.
- AFinancial correlation riskCorrect
- BBasis risk from dividend forecasting
- CDefault intensity risk
- DPure liquidity risk
Explanation
Financial correlation risk is the risk that correlations in a model or portfolio change unfavorably or differ from assumed values. The other terms describe different risks: basis risk concerns hedge mismatch, default intensity concerns default timing, and liquidity risk concerns trading ability.
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