medium · Frm Part 2 Market Risk
A bank uses a internal VaR model for market risk. A supervisor notes that the model uses a constant correlation matrix estimated over a 5-year calm period.
Why is this model likely to fail during a market crash?
- Correlations tend to spike toward 1.0 during crises, reducing diversification benefits.
- The model will produce too many Type I errors during the calm period.
- Constant correlation models cannot handle the non-linear deltas of option books.
- Calm-period data is always stationary, while crash data is non-stationary.
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