[ 2009 FRM Sample Exam ] Market risk measurement and management Q30 management, describes, therefore, benefits, decrease

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30. Which statement best describes correlations and variances in times of financial crisis?

A. There are only marginal changes in correlations and variances in times of crisis and therefore they do not need to be factored into risk management.

B. The diversification benefits decrease as correlations increase and therefore your risk level increases.

C. The diversification benefits increase as correlations decrease and therefore your risk level decreases.

D. VaR estimates using the Riskmetrics approach provide for the effects of increased correlations during periods of crisis and therefore the effects are factored into current positions.

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Babul

 

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A is incorrect because during crisis situations the correlation between global markets increases as suggested by empirical evidence.

B is correct because during crisis situations the correlation between global markets increases as suggested by empirical evidence. The implication of this increased correlation is that the maximum amount to be lost for a given probability over a given time period increases. Therefore, diversification benefits decrease when correlations rise and therefore the risk level increases.

C is incorrect because during crisis situations the correlation between global markets increases as suggested by empirical evidence. The implication of this increased correlation is that the maximum amount to be lost for a given probability over a given time period increases. Therefore, diversification benefits decrease when correlations rise and therefore the risk level increases (and not decreases).

D is incorrect because VAR estimates do not provide for the effects of increased correlations during periods of crisis. Stress testing can be used to evaluate the effects of increased correlations.

References: Allen, Boudoukh and Saunders, Understanding Market, Credit, and Operational Risk, Chapters 1,3; Neil D. Pearson, Risk Budgeting: Portfolio Problem Solving with Value?at?Risk (ffice:smarttags" />New York: Wiley, 2002), Chapter 9.