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

A risk manager uses a bivariate normal model to build a scenario. The core factor is equity return with annual standard deviation 20%, and the scenario shock is -30%. The second factor is the change in credit spreads, with standard deviation 50 bp and correlation -0.6 to equity returns. Both factors have zero mean. What is the conditional expected spread change in the scenario?

The conditional expected spread change is +45 bp. It is correlation times the ratio of volatilities times the core shock: -0.6 x (50/20) x (-30%) = +45 bp. Spreads widen when equities fall because the correlation is negative.

  1. A+45 bpCorrect
  2. B+75 bp
  3. C-45 bp
  4. D+18 bp

Explanation

The conditional expectation is rho x (sigma_y/sigma_x) x shock = -0.6 x (50/20) x (-30) = -1.5 x (-30) = +45 bp. Using +75 bp ignores the correlation, -45 bp has the wrong sign, and +18 omits the volatility ratio.

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