FRM Part II · FRM Exam Part II · Factor Theory
A sovereign wealth fund notes that its factor exposures are well diversified in normal markets, but factor correlations tend to rise and several premia suffer drawdowns simultaneously in severe downturns. Which response is most consistent with robust factor allocation?
The fund should stress test using crisis-period correlations and diversify across factors with different economic risk drivers. Because factor correlations rise in downturns, average historical correlations overstate diversification, and concentrating in past winners increases estimation and crowding risk.
- ARely solely on historical average correlations to size positions
- BStress test the allocation using crisis-period correlations and consider factors with different economic risk driversCorrect
- CConcentrate in the factor with the highest past Sharpe ratio
- DEliminate all factor exposures and hold cash only
Explanation
Correlations are unstable and rise in stress, so average-correlation estimates overstate diversification. Stress testing with crisis correlations and diversifying across factors with distinct economic drivers addresses this. Concentrating in the best past performer adds estimation and crowding risk.
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