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

A risk manager reviewing a structured credit book notes that during the 2007-2009 crisis, losses on CDO tranches far exceeded model predictions even though individual default probabilities were estimated reasonably well. Which statement best describes the correlation risk that was underestimated?

Default correlation increased sharply in stressed markets, making simultaneous defaults far more likely than the models assumed. Because tranche losses depend on joint defaults, this unmodeled rise in correlation caused losses well beyond predictions, even though individual default probabilities were reasonably estimated.

  1. ADefault correlation rose sharply in stressed markets, so joint defaults were much more likely than the models assumedCorrect
  2. BDefault correlation fell in stressed markets, which reduced diversification benefits
  3. CCorrelation between interest rates and equity returns became constant over time
  4. DPearson correlation was undefined because defaults are binary outcomes

Explanation

Financial correlation risk is the risk that correlations change adversely. In crises, default correlations tend to increase, making joint defaults more frequent and hitting senior and mezzanine tranches harder than models calibrated to calm periods predicted. Falling correlation would have reduced, not increased, such losses.

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