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FRM Part II · FRM Exam Part II · The Financial Stability Implications of Artificial Intelligence

A trading desk uses AI models to generate signals, and many market participants adopt similar models trained on comparable data. Which market-level risk does this adoption most plausibly amplify during stress?

Widespread use of similar AI models and data can cause herding, where many participants trade in the same direction simultaneously. This procyclical behaviour increases correlation and volatility and can drain liquidity in stress, rather than reducing risk through diversification.

  1. AHerding and procyclical behaviour that increases correlated trades and market volatilityCorrect
  2. BA guaranteed reduction in volatility from diversified strategies
  3. CElimination of liquidity risk because models trade faster
  4. DA decrease in correlations across participants' positions

Explanation

Similar models and data can lead to simultaneous selling or buying, amplifying shocks and reducing liquidity in stress. Speed does not remove liquidity risk, and correlation across positions would rise, not fall.

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