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

A trader notes that correlations between equity returns rose sharply during a market sell-off compared with calm periods. For risk management, which implication is most accurate?

Diversification benefits measured with calm-period correlations may be overstated, because correlations tend to rise in stress. Higher correlation increases portfolio variance and VaR, so stress-period correlations should be considered in risk measurement.

  1. ADiversification benefits estimated from calm-period correlations may be overstated in stressCorrect
  2. BDiversification benefits are larger in stress
  3. CPortfolio VaR falls because correlations rise
  4. DCorrelation is constant so the estimate is unaffected

Explanation

Correlations tend to increase in stressed markets, which reduces diversification. Using calm-period correlations would understate portfolio VaR and overstate diversification benefit. Higher correlation raises portfolio variance, not lowers it.

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