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

A scenario designer shocks factor A by -3 standard deviations and sets factor B at its conditional expected value, with correlation 0.8. She notes that the actual loss on B in a real crisis was much larger than the scenario implied. Which is the most likely explanation consistent with the market-driven scenario framework?

Correlations typically increase in stress, so a conditional expectation using normal-period correlation understates the move in B. The conditional mean is only the average outcome; residual variance remains and tails can be fatter than normal.

  1. ACorrelations tend to rise in stress, so the conditional expectation based on normal-period correlation understates B's moveCorrect
  2. BThe conditional expectation of B has a variance of zero, so B cannot deviate
  3. CConditional expected shocks always overstate co-movement when correlation exceeds 0.5
  4. DThe shock to A should have been set in absolute terms rather than standard deviations

Explanation

Conditional means scale with the correlation estimate. If stress correlations exceed the estimated 0.8, or distributions are fat-tailed, B moves more than predicted. The conditional variance is not zero (it is 1-rho² of B's variance), so the second option is false. The others have no basis.

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