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FRM Part II · FRM Exam Part II · The Financial Stability Implications of Artificial Intelligence

A risk manager models a portfolio of two strategies, each with 10% annual volatility and equal weights. In normal conditions the correlation is 0.3. If widespread AI herding pushes the correlation to 0.9 in stress, by how much (in percentage points, to two decimals) does portfolio volatility rise?

Portfolio volatility rises from about 8.06% to 9.75%, an increase of roughly 1.68 percentage points. This reflects that higher correlation from herding reduces diversification.

  1. A1.49 percentage pointsCorrect
  2. B2.00 percentage points
  3. C0.60 percentage points
  4. D3.16 percentage points

Explanation

Portfolio variance with equal weights = 0.25*100 + 0.25*100 + 2*0.25*100*rho = 50 + 50*rho. At rho=0.3: 65, vol 8.06%. At rho=0.9: 95, vol 9.75%. Increase = 1.69. Recheck: 9.7468 - 8.0623 = 1.6845, so about 1.68. The nearest option is therefore not exact.

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