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

A risk team constructs a scenario by shocking the 10-year Treasury yield and using a historical covariance matrix to set the other factor moves. A reviewer argues the resulting scenario may understate crisis outcomes. What is the most relevant criticism?

The main criticism is that correlations estimated in normal conditions often rise during crises, so the implied moves in other factors may be too small and the scenario understates stress outcomes. The approach works with many correlated factors and does not guarantee severity.

  1. AConditional expectations from correlations estimated in normal periods may not hold in crises, when dependence typically increasesCorrect
  2. BThe method requires the shocked factor to be uncorrelated with all other factors
  3. CUsing a covariance matrix guarantees the scenario is more severe than any historical event
  4. DThe method cannot be applied to more than two risk factors

Explanation

Correlations estimated in calm periods tend to rise in stress, so projected co-movements can be too mild. The method does not require zero correlation, does not guarantee extreme severity, and handles many factors through the covariance matrix.

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