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FRM Part II · FRM Exam Part II · Portfolio Risk: Analytical Methods

During a market crisis, a bank's analytical VaR, based on a covariance matrix estimated over a calm two-year window, shows a diversified portfolio of equities and corporate bonds with low risk. Stress testing instead assumes that correlations between asset classes move toward one. What is the main reason this stress scenario is informative beyond the VaR figure?

The stress test reveals that diversification benefits measured in calm periods can disappear when correlations rise toward one in a crisis. Portfolio losses could then greatly exceed the covariance-based VaR, which is the key weakness of relying only on historically estimated correlations.

  1. AIt shows that diversification benefits estimated in normal times can vanish, so losses may exceed the VaR estimateCorrect
  2. BIt proves that volatility is constant across all market regimes
  3. CIt removes the need for any confidence level in risk measurement
  4. DIt shows that the covariance matrix is always positive definite in crises

Explanation

Analytical VaR relies on historical correlations that may be unstable. In crises correlations typically rise, eliminating diversification benefits and increasing portfolio loss. A stress test with correlations near one exposes this breakdown, which a calm-period covariance matrix cannot reveal.

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