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

An analyst builds a market-driven scenario assuming returns on a portfolio's risk factors are jointly normal with zero mean. Factor X (equity index) has a standard deviation of 4% and factor Y (credit spread change proxy return) has a standard deviation of 2%, with correlation -0.5. The scenario shocks X by -8%. What is the conditional expected move in Y?

The conditional expected move in Y is +2.0%. It equals correlation times the ratio of volatilities times the shock: -0.5 × (2%/4%) × (-8%). The negative correlation flips the sign of the equity shock, and the volatility ratio scales it down.

  1. A+2.0%Correct
  2. B-4.0%
  3. C+4.0%
  4. D+1.0%

Explanation

Conditional mean of Y = rho*(sigma_Y/sigma_X)*shock = -0.5*(2/4)*(-8%) = +2.0%. Using -2% would come from ignoring the negative sign of the correlation. Using +4% omits the correlation factor of 0.5, and +1% wrongly scales by an extra half.

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