FRM Part II · FRM Exam Part II · Factors
A risk manager notes that two factor strategies had a correlation of 0.1 in calm markets but 0.7 during a crisis. What is the most appropriate implication for factor diversification?
Factor correlations tend to rise in crises, so diversification benefits measured in calm markets are overstated. Higher correlation increases portfolio volatility for the same weights, so risk managers should stress-test using crisis correlations.
- ADiversification benefits estimated from calm-period correlations may be overstated in stress periodsCorrect
- BDiversification benefits are always larger in crises
- CCorrelation changes do not affect portfolio volatility
- DThe strategies should be treated as perfectly hedged in all regimes
Explanation
Higher correlation raises portfolio variance for given weights, so benefits estimated in calm periods overstate stress-period diversification. The other options contradict this relationship.
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