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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 as the stress driver and then deriving the shocks to all other factors from their historical co-movement with it. Which description best matches how the conditional expected shock to another factor is obtained in this approach?

The conditional expected shock to another factor is its expected move given the driver's shock, estimated from the historical correlation and the relative volatilities of the two factors. It is not a worst-ever move, an identical shock, or an unconditional random draw, because those ignore the co-movement structure.

  1. AThe expected move in the other factor given the driver's shock, based on the estimated correlation and relative volatilities of the two factorsCorrect
  2. BThe largest historical move ever observed in the other factor, regardless of what the driver did
  3. CThe driver's shock applied unchanged to every other factor in the portfolio
  4. DA random draw from the other factor's unconditional distribution that ignores the driver

Explanation

Market-driven scenarios use the statistical relationship between factors to set the expected shock to the other factors conditional on the driver's shock. Under a joint-normal setup this depends on the correlation and the ratio of volatilities. Applying the same shock to all factors ignores differing sensitivities and volatilities, and ignoring the driver discards the conditioning.

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