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

A firm designs a stress scenario by choosing the shocked factors first and then assessing the plausibility of the whole scenario. Which approach is most consistent with the idea of market-driven plausibility?

Plausibility is best assessed by measuring how far the joint scenario sits from the center of the factors' joint distribution, using a distance that accounts for correlations. Counting factors, applying equal shocks, or discarding data does not capture how unusual the combined move is.

  1. AMeasuring how far the scenario lies from the center of the factors' joint distribution, accounting for correlationsCorrect
  2. BCounting the number of factors shocked and preferring the largest count
  3. CIgnoring historical data because the future will differ from the past
  4. DApplying equal-sized shocks to all factors to keep the scenario simple

Explanation

Plausibility can be gauged by how unusual the joint scenario is, using a distance measure that incorporates covariances (Mahalanobis-type). Simply counting factors, equal shocks, or ignoring data does not measure plausibility of the joint move.

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