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

A portfolio manager uses a market-driven approach in which a stress on a chosen core risk factor is propagated to other factors using their observed relationships in market data. Which statement best describes the benefit of this approach over specifying every factor shock by expert judgment?

The approach makes shocks to the other risk factors consistent with relationships observed in the market, improving plausibility and reducing reliance on subjective expert judgment. It does not guarantee a worst case or remove model risk.

  1. AIt guarantees the scenario is the worst possible outcome
  2. BIt removes the need to choose any core factor
  3. CIt makes shocks to the remaining factors consistent with market-observed relationships, improving plausibility and reducing subjectivityCorrect
  4. DIt eliminates all model risk in stress testing

Explanation

Propagating a core shock through empirically observed relationships yields coherent shocks to other factors with less arbitrary judgment. It does not guarantee worst case, still needs a core factor choice, and cannot eliminate model risk.

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