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

An analyst stresses factor A by a 2-standard-deviation fall. Factor B has correlation 0.6 with A. Relative to an unconditional scenario where B is not moved, what does the conditional approach imply for B's expected move in standard deviation units?

Factor B is expected to fall by 1.2 standard deviations. Under joint normality the conditional expected move in standardized terms equals correlation times the shock: 0.6 × -2 = -1.2. Assuming a full 2.0 would imply perfect correlation.

  1. AA fall of 1.2 standard deviationsCorrect
  2. BA fall of 2.0 standard deviations
  3. CA fall of 0.6 standard deviations
  4. DA fall of 3.33 standard deviations

Explanation

In standardized units the conditional mean of B equals rho times A's shock: 0.6 × -2 = -1.2 standard deviations. Using -2.0 assumes perfect correlation; -0.6 forgets to multiply by the shock size; 3.33 divides instead of multiplies.

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