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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 in which equity prices fall sharply. In a market-driven approach, how should the team set the moves in other risk factors, such as credit spreads?

Other risk factors should be set to the moves most likely to accompany the primary shock, using the joint distribution implied by market data, such as correlations. Holding them at zero, copying the equity move, or choosing the least harmful values would not give a plausible stress scenario.

  1. ASet them to zero so that the equity effect is isolated
  2. BSet them using the same percentage move as equities
  3. CChoose them as the moves most likely to occur given the equity shock, based on the joint distribution implied by market dataCorrect
  4. DChoose the moves that make the portfolio loss smallest

Explanation

Other factors are set conditionally: given the primary shock, the expected moves in correlated factors follow from the estimated joint behavior. Setting them to zero ignores correlation and may understate or distort loss; copying the equity move has no basis; minimizing loss defeats stress testing.

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