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

A risk team builds a market-driven scenario by choosing one risk factor to shock severely and then setting the other factors at their expected values conditional on that shock. Which statistical relationship is the main input used to set the conditional moves in the other factors?

The covariance (or correlation plus volatility) matrix of factor returns is used. It lets the analyst project the severe shock in one factor onto the others, giving their expected moves conditional on that shock. Standalone volatilities or exposures ignore how factors co-move.

  1. AThe historical covariance matrix of factor returns, used to project the shock onto the other factorsCorrect
  2. BThe implied volatility of each factor taken separately
  3. CThe fixed notional exposure of the portfolio to each factor
  4. DThe credit rating of the counterparties in the portfolio

Explanation

Conditional expected shocks come from the joint distribution of factors, typically assumed multivariate normal. The covariance matrix tells how much each other factor is expected to move given the stressed factor. Standalone volatilities ignore co-movement, and exposures or ratings are not part of the conditioning.

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