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

A risk manager at an asset manager builds a stress scenario by first choosing a small set of market variables, such as equity index and credit spreads, to be shocked. She then uses the historical joint distribution of all other risk factors to infer their likely moves given those shocks. What is the main advantage of this market-driven approach over a purely hand-picked scenario that specifies every factor shock?

The approach keeps the unspecified risk factors consistent with how they historically co-move with the shocked variables, so the scenario is internally coherent and more plausible. It does not replicate VaR, still requires judgment in choosing the shocks, and can be tailored to the portfolio.

  1. AIt guarantees that the scenario loss equals the 99% VaR of the portfolio
  2. BIt keeps the shocks to non-specified factors consistent with the historical co-movement, making the scenario more plausibleCorrect
  3. CIt removes the need for the manager to use any judgment in selecting the shocked variables
  4. DIt makes the scenario independent of the portfolio being analyzed

Explanation

Market-driven scenarios shock a few chosen variables and let the remaining factors move in line with their estimated joint relationships. This yields internally consistent, plausible scenarios. The approach does not equal VaR, and judgment is still needed to choose the shocked variables.

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