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

A risk manager notes that during a market crisis, correlations among equity returns rise sharply compared with calm periods. What is the main implication for portfolio risk estimated using calm-period correlations?

Calm-period correlations understate crisis dependence. When correlations rise, diversification benefits shrink, so portfolio VaR based on the lower correlations underestimates true risk. This is why stress testing with higher correlation assumptions is important.

  1. ADiversification benefits are overstated and portfolio risk is underestimatedCorrect
  2. BPortfolio risk is overestimated because volatilities fall
  3. CDiversification benefits are understated
  4. DPortfolio VaR is unaffected as correlation does not enter it

Explanation

Higher correlations reduce diversification, so using lower calm-period correlations understates portfolio variance and VaR in stress. Correlation is a direct input to portfolio risk.

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