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

After running a market-driven scenario, a risk manager finds a large loss, but most of it stems from a factor that the scenario did not directly shock and was only moved through its implied relationship. What is the most appropriate interpretation?

The loss signals hidden exposure to a factor that is correlated with the shocked variables. Such indirect exposure is exactly what market-driven scenarios are designed to reveal, so the manager should investigate and consider hedging rather than dismissing the implied shocks.

  1. AThe result is invalid because only directly shocked factors may contribute to losses
  2. BThe portfolio has significant hidden exposure to a factor correlated with the chosen shock variables, which the manager should review and possibly hedgeCorrect
  3. CThe scenario should be discarded because implied shocks are always overstated
  4. DThe loss is a pure model artefact and can be ignored in limit setting

Explanation

A major loss from implied factor moves reveals concentrated indirect exposure to variables that co-move with the shocked ones. This is a useful insight that traditional single-factor stress tests would miss. It should inform review and hedging, not be dismissed.

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