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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 stress scenario by choosing a severe shock to equity prices and then setting the moves in credit spreads, rates and FX from the historical joint distribution of those factors. Compared with a purely hypothetical scenario in which every factor shock is set by judgment, what is the main advantage of this method?

The method's main advantage is internal consistency. Non-core factor shocks are derived from their observed joint behavior with the core shocked factor, so the scenario is coherent and plausible, unlike judgmental scenarios that may combine moves that rarely occur together.

  1. AEvery other factor's shock is consistent with its observed relationship to the core factor, so the scenario is internally coherent and more plausibleCorrect
  2. BIt guarantees that the scenario loss equals the 99% VaR of the portfolio
  3. CIt removes the need to choose a core stress factor
  4. DIt ensures that all risk factors move in the adverse direction for the portfolio

Explanation

Conditioning the non-core factors on the core shock using the estimated covariance structure makes the combined moves consistent with how markets have behaved together. It does not tie the loss to a VaR level, remove the need for a core factor, or force every move to hurt the portfolio.

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