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

A stress tester builds a scenario in which equity prices fall sharply. The analyst wants the other risk factors, such as credit spreads and rates, to move consistently with the equity shock rather than being set independently. Which construction step best accomplishes this?

The analyst should use the dependence between risk factors, such as correlations or conditional expectations, to derive the other shocks given the equity shock. This keeps the scenario internally coherent, unlike holding factors constant, applying uniform percentages, or combining unrelated worst historical moves.

  1. AHold all non-equity risk factors constant at current levels
  2. BShock every factor by the same percentage as equities
  3. CSet each factor's shock to its own worst historical move, regardless of timing
  4. DUse the dependence between factors, such as correlations or conditional expectations, to derive the remaining shocks given the equity shockCorrect

Explanation

Plausible scenarios require internally coherent shocks. Using the dependence structure to compute the conditional shocks of other factors given the primary shock keeps the scenario consistent. Holding factors constant or using the same percentage ignores dependence, and combining independent worst moves overstates joint severity and is implausible.

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