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

Two candidate scenarios both produce a portfolio loss of USD 50 million. Scenario A has a Mahalanobis distance from current market conditions much larger than Scenario B. Using a plausibility measure based on this distance, which conclusion is most appropriate?

Scenario B is more plausible. The Mahalanobis distance measures how unusual a joint shock is given volatilities and correlations, so a smaller distance means a more likely scenario. With identical losses, the scenario with the smaller distance should be judged more plausible.

  1. AScenario A is more plausible because larger distances indicate larger losses
  2. BScenario B is more plausible because its shocks are statistically closer to normal market co-movementsCorrect
  3. CThe two scenarios are equally plausible because the loss is identical
  4. DPlausibility cannot be compared unless the scenarios involve the same risk factors

Explanation

Mahalanobis distance measures how far a shock vector is from the center, accounting for volatilities and correlations. A larger distance means a less likely scenario. With equal losses, Scenario B, with the smaller distance, is more plausible.

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