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

A portfolio has a 10% allocation to a hedge fund strategy whose loss in a stress scenario is estimated by two methods. Method A shocks only equities by -25%, holding rates and spreads fixed, giving a portfolio loss of 6.0%. Method B uses a market-driven scenario with the same -25% equity shock but lets rates fall 100 bp and spreads widen 150 bp, giving a loss of 8.5%. The portfolio holds long-duration bonds that gain from falling rates and credit positions that lose from wider spreads. Which conclusion is best supported?

Method A understated the stress loss. Under the same equity shock, the market-driven scenario also moved rates and spreads, and the loss rose from 6.0% to 8.5%. This means spread-widening losses on credit positions outweighed duration gains from falling rates, which the single-factor shock ignored.

  1. AMethod A is superior because it isolates the equity effect and is therefore more plausible
  2. BThe extra loss in Method B shows spread widening losses exceed the duration gains from falling rates, so Method A understated the stress lossCorrect
  3. CMethod B must be wrong because falling rates should reduce losses more than spreads increase them
  4. DThe two methods differ only because of sampling error in the equity shock

Explanation

Method B adds rate and spread moves to the same equity shock and loss rises from 6.0% to 8.5%, a net 2.5% increase from the additional factors. Hence credit losses outweighed duration gains, and Method A, ignoring co-movement, understated the loss. The equity shock is identical, so sampling error does not explain the difference.

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