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FRM Part II · FRM Exam Part II · Market-Driven Scenarios: An Approach for Plausible Scenario Construction

A committee reviews a stress scenario and says it is implausible because the combined shocks would be extremely unlikely given market-implied relationships. In the market-driven framework, which measure is most appropriate to quantify this plausibility of a multi-factor scenario?

A Mahalanobis-type distance is most appropriate, because it measures how extreme a joint shock is after accounting for each factor's volatility and the correlations between factors. Summing shocks, looking at portfolio value, or counting factors does not capture how unlikely the combination is.

  1. AThe simple sum of the individual factor shocks
  2. BA Mahalanobis-type distance that accounts for the volatilities and correlations of the factorsCorrect
  3. CThe portfolio's current market value
  4. DThe number of risk factors shocked

Explanation

Plausibility of a joint shock is judged by how far it lies from the center of the joint distribution, scaled by covariance, which is what a Mahalanobis distance captures. A simple sum ignores volatilities and correlations; portfolio value and factor count say nothing about likelihood.

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