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

A portfolio manager notes that VaR at 99% says nothing about losses beyond the threshold. Which is the main reason scenario analysis complements VaR?

Scenario analysis complements VaR because it lets managers examine specific severe or unprecedented events in the tail, which history-based statistical models may understate and which a quantile threshold does not describe. It does not give exact probabilities or always smaller losses.

  1. AScenario analysis always produces a lower loss estimate than VaR
  2. BScenario analysis removes the need to estimate any risk factor distributions
  3. CScenario analysis can explore specific severe, possibly unprecedented events in the tail that statistical models calibrated to history may understateCorrect
  4. DScenario analysis guarantees that probabilities of each event are exactly known

Explanation

Scenarios let managers examine specific extreme events and their effects on the portfolio, including ones absent from historical data. VaR is limited to a quantile and relies on historical or assumed distributions. Scenarios do not provide exactly known probabilities, and are not systematically lower.

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