FRM Part II · FRM Exam Part II · Factor Theory
A risk manager notes that during a severe equity market sell-off, several normally low-correlated factor premiums (value, size, and a credit-spread carry factor) all suffered losses simultaneously. Which conclusion is most consistent with factor theory regarding diversification across factors?
Correlations among risky factor premiums tend to rise during market stress, so diversification benefits shrink precisely when investors need them. This is consistent with premiums compensating for bad-times risk, and does not make diversification worthless or the factors invalid.
- AFactor diversification is ineffective and should be abandoned
- BThe factors were mis-specified because factor returns must always be uncorrelated
- CCorrelations among risky factor premiums tend to rise in bad times, so diversification benefits shrink when most neededCorrect
- DValue, size, and carry are not genuine risk premiums because they lost money
Explanation
Many factor premiums are compensation for bearing bad-times risk, and their correlations tend to increase in crises, reducing diversification benefits. This does not mean diversification is useless on average, and factors need not be uncorrelated. Losses in a downturn are consistent with, not contrary to, a risk-based premium.
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