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

A market-driven scenario shows a $40 million loss for a trading book, concentrated in one illiquid credit position. The head of risk is deciding how to interpret the result. Which interpretation is most appropriate?

The $40 million is a conditional loss, assuming the scenario happens, not an expected or probability-weighted loss. It should be compared with risk appetite and limits and used to expose the concentration in the illiquid credit position so management can decide on hedging or limit changes.

  1. AThe loss is conditional on the scenario occurring, so it should be compared with risk appetite and limits and used to identify the concentration, not read as a probability-weighted lossCorrect
  2. BThe loss is the expected loss over the next year and should be provisioned in full
  3. CThe loss is below the VaR figure by construction, so no action is needed
  4. DThe concentration can be ignored because the scenario factors were chosen from historical data

Explanation

A scenario loss is conditional on the shock occurring and carries no probability by itself. Its value lies in showing vulnerabilities, such as the concentrated illiquid position, against risk appetite and limits, and in prompting management action. It is not an expected loss, and it has no fixed relation to VaR. Historical calibration does not remove a concentration.

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