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

When assessing whether a market-driven scenario is plausible, a risk manager compares the scenario's joint factor moves with the historical distribution. Which measure most directly indicates how unlikely the joint move is, taking correlations into account?

The Mahalanobis distance is the best measure. It uses the covariance matrix to judge how far the joint shock vector lies from normal behavior, capturing both volatilities and correlations, so a combination of moves inconsistent with usual dependence appears as less plausible.

  1. AThe sum of the absolute shocks across factors
  2. BThe Mahalanobis distance of the shock vector from the mean using the covariance matrixCorrect
  3. CThe largest individual shock expressed in percent
  4. DThe average of the factor volatilities

Explanation

Mahalanobis distance scales the shock vector by the covariance matrix, so it reflects both magnitude and whether the combination of moves is consistent with observed correlations. The other measures ignore dependence or scaling by volatility.

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