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FRM Part II · FRM Exam Part II · Advances in Artificial Intelligence: Implications for Capital Markets Activities

Several large trading firms deploy AI-driven strategies trained on similar historical data and optimizing similar objectives. During a sudden volatility spike, the models all generate sell signals within seconds. Which mechanism best explains why this could amplify market stress?

Model homogeneity causes correlated behavior. Similar AI models trained on similar data react in the same way to the same shock, producing herding and procyclical selling at the same moment, which reduces market diversity and amplifies volatility and liquidity strain.

  1. AModel homogeneity leading to correlated behavior and herding, which reduces diversity of views and increases procyclical sellingCorrect
  2. BHigher information asymmetry, since each model hides its data from the others, which stabilizes prices
  3. CGreater diversification of trading strategies across firms, which lowers the correlation of positions
  4. DLower speed of execution, which gives human traders time to absorb the selling

Explanation

When models share similar training data and objectives, their responses become correlated, producing herding and procyclical flows that can magnify price moves and cause liquidity to vanish. Diversification and slower execution would mitigate rather than amplify stress.

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