FRM Part II · FRM Exam Part II · Market-Driven Scenarios: An Approach for Plausible Scenario Construction
A practitioner notes that historical correlations between a stress driver and other risk factors are much higher during crisis periods than in calm periods. What is the most appropriate implication for constructing a market-driven scenario?
The scenario builder should consider estimating correlations from stressed periods. When correlations rise in crises, full-sample estimates understate how far other factors are expected to move given the driver's shock, so the scenario would understate losses. Setting correlations to zero or ignoring other factors discards the co-movement.
- AUse the full-sample correlation, since it uses the most data and is therefore always the most reliable
- BSet all correlations to zero so that factor shocks are independent
- CConsider estimating correlations from stressed periods, because full-sample correlations may understate conditional co-movement in a crisisCorrect
- DUse only the driver's shock and leave all other factors unchanged
Explanation
If correlations rise in stress, a full-sample estimate understates the conditional shocks to other factors and therefore the scenario loss. Using stress-period or stress-weighted correlations produces more plausible joint shocks. Zero correlation or ignoring other factors would remove the co-movement the approach is meant to capture.
Did you get it right without looking?
One question tells you little. A timed set on Market-Driven Scenarios: An Approach for Plausible Scenario Construction shows your real accuracy, how long you take and where you lose marks.
More Market-Driven Scenarios: An Approach for Plausible Scenario Construction questions
- A risk team builds a stress scenario in which equity prices fall sharply. In a market-driven approach, how should the team set the moves in …
- A risk team builds a market-driven scenario by choosing one risk factor to shock severely and then setting the other factors at their expect…
- A risk manager uses a linear relationship to propagate a stress shock. Factor X (an equity index) is shocked by -20%. Historically, factor Y…
- An analyst builds a market-driven scenario assuming returns on a portfolio's risk factors are jointly normal with zero mean. Factor X (equit…
- A risk team builds a market-driven scenario by choosing one risk factor as the stress driver and then deriving the shocks to all other facto…
- A risk manager uses a bivariate normal model to build a scenario. The core factor is equity return with annual standard deviation 20%, and t…