FRM Part II · FRM Exam Part II · Range of Practices and Issues in Economic Capital Frameworks

A risk manager notes that the diversification benefit calculated from historical correlations across business lines fell sharply during a recent crisis. Which is the most appropriate conclusion about using these correlations in economic capital aggregation?

Correlations typically rise in stress, so a diversification benefit estimated from normal-period data may overstate the protection available in the tail. Economic capital aggregation should therefore consider stressed dependence rather than rely only on historical average correlations.

1. ACorrelations tend to rise in stress, so a benefit estimated in normal times may overstate protection in the tailCorrect
2. BCorrelations are stable, so the crisis observation should be discarded as an outlier
3. CCorrelations fall in stress, so the benefit estimated in normal times is understated
4. DDiversification benefit is independent of correlation and depends only on the number of business lines