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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 stress scenario by shocking only equity prices by -30% and leaving credit spreads, volatility and rates unchanged. Which is the most important criticism from a plausible-scenario construction perspective?

The main criticism is that shocking equities alone ignores the joint movements that normally accompany a crash, such as wider spreads and higher volatility. Plausible scenarios need internally consistent co-movements across risk factors, otherwise losses may be misestimated.

  1. AThe shock is too small to be informative
  2. BEquity shocks cannot be applied to a diversified portfolio
  3. CRisk factors are shocked in isolation, ignoring the joint movements that typically accompany an equity crash, so the scenario is internally inconsistentCorrect
  4. DThe scenario uses a percentage rather than an absolute shock

Explanation

A plausible scenario must have coherent co-movements: a 30% equity fall would normally coincide with wider credit spreads, higher implied volatility and lower rates. Shocking one factor in isolation produces an implausible scenario and can misstate losses.

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