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FRM Part I · FRM Exam Part I · Measuring Return, Volatility, and Correlation

During a market crisis, a risk manager observes that the correlation between two equity portfolios rises sharply compared with calm periods. Which implication is most consistent with this finding for risk measurement?

Diversification benefits measured with average, full-sample correlations probably overstate protection during stress. Correlations tend to rise in crises, which increases portfolio variance and VaR relative to estimates built mostly from calm periods, so stress-conditional correlations should be considered.

  1. ADiversification benefits estimated from full-sample correlation likely overstate protection in stress periodsCorrect
  2. BDiversification benefits are larger in stress periods than in calm periods
  3. CCorrelation is constant, so the observed change must be sampling error
  4. DPortfolio VaR must fall because higher correlation reduces variance

Explanation

Correlations tend to increase in stressed markets, so a full-sample estimate dominated by calm periods understates joint downside risk. Higher correlation raises portfolio variance, not lowers it, so VaR based on average correlation is too low in crises.

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