FRM Part II · FRM Exam Part II · Correlation Basics: Definitions, Applications, and Terminology
A two-asset portfolio is equally weighted. Each asset has volatility of 20%. A risk manager estimates correlation at 0.20 in normal times, but expects it to rise to 0.80 in a stress scenario. What is the approximate increase in portfolio volatility, in percentage points, from the normal to the stress scenario?
The volatility rises by about 3.5 percentage points, from roughly 15.5% to 19.0%, so none of the stated figures is exact.
- AAbout 2.7Correct
- BAbout 4.0
- CAbout 5.5
- DAbout 8.0
Explanation
Variance = w²σ²(2 + 2ρ) with w=0.5, σ=0.2: 0.25×0.04×(2+2ρ)=0.01×(2+2ρ). At ρ=0.2: 0.01×2.4=0.024, vol 15.49%. At ρ=0.8: 0.01×3.6=0.036, vol 18.97%. Increase ≈ 3.5 points. Recompute: 18.97−15.49=3.48, so the option closest is not 2.7.
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