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

A fund's stress testing team notes that its existing scenario set is dominated by hypothetical shocks chosen by senior management, such as a 30% equity fall with all other factors unchanged. Which is the main weakness of such scenarios that plausible scenario construction aims to address?

The main weakness is that shocking one factor while holding the others constant ignores how risk factors move together. The resulting scenario can be economically implausible and give misleading loss estimates, which plausible scenario construction tries to fix by letting other factors respond to the shock.

  1. AThey cannot be applied to portfolios holding derivatives
  2. BHolding unshocked factors constant may imply economically implausible combinations of moves, so loss estimates can be misleadingCorrect
  3. CThey always overstate losses relative to VaR at the 99% level
  4. DThey require a full probability distribution of every risk factor to be estimated

Explanation

Shocking one factor while leaving others fixed ignores the way markets co-move, so the scenario may be implausible and may mis-state portfolio losses, either too high or too low. Such scenarios can be applied to derivatives, are not systematically larger than VaR, and do not require full distributions.

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