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

A risk committee notes that its scenario, built from conditional expected shocks using historical correlations, understates losses in a crisis. Which is the most appropriate explanation tied to this method?

Historical-average correlations typically understate co-movement in a crisis, when correlations rise. Because conditional expected shocks scale directly with correlation, the resulting scenario shocks to other factors, and the portfolio losses, come out too small.

  1. ACorrelations tend to rise in stressed markets, so historical-average correlations understate co-movement and conditional shocksCorrect
  2. BConditional expected shocks always overstate co-movement because they use regression betas
  3. CThe method requires factors to be uncorrelated, which was violated
  4. DConditional expected shocks are independent of the stressed factor's size

Explanation

Conditional shocks scale with correlation; if crisis correlations exceed the estimation-period values, the implied co-movements and losses are too small. The other statements are false: shocks depend on correlation and shock size, and the method relies on correlation, not independence.

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