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

A practitioner is designing a market-driven scenario and wants to avoid the weakness of stress tests based on a narrative that specifies shocks to only a few factors. Which approach best addresses this weakness?

The best approach is to shock the factors named in the narrative and set the remaining risk factors to their conditional expected values given those shocks. This produces a complete, coherent scenario covering all portfolio exposures, rather than leaving unspecified factors ignored or arbitrarily assigned.

  1. ALimit the scenario to the factors named in the narrative and ignore all others
  2. BShock the named factors, then let the remaining portfolio risk factors move to their expected values conditional on those shocksCorrect
  3. CIncrease the size of the named shocks until portfolio loss reaches a target
  4. DReplace the narrative with the portfolio's one-day 99% VaR

Explanation

Narrative scenarios often specify only some factors, leaving others unspecified or arbitrarily set. Propagating the specified shocks to remaining factors through conditional expectations gives a complete, coherent scenario. Ignoring factors omits exposures, and scaling shocks or using VaR does not address completeness.

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