Which of the following statements are true:
I,Shocks to risk factors should be relative rather than absolute if we wish to avoid a change in the sign of the risk factor.
II,Interest rate shocks are generally modeled as absolute shocks.
III,Shocks to volatility are generally modeled as absolute shocks.
IV. Shocks to market spreads are generally modeled as relative shocks.
Suppose during a historical event interest rates rose from 2% to 2.25%. This can be understood as a change of either 25 basis points, or a change of 12.5%. When applied to the current portfolio when interest rates are 0.50%, we may model this 'shock' as either a rise to 0.75%, or 0.5625% (ie a rise of 12.5% over existing levels). The former is called an absolute shock, and the latter a relative shock.
I is true as relative shocks can never change the sign of a risk factor. Yet interest rate changes are modeled as absolute changes as relative shocks can get artificially amplified or attenuated if the current level of interest rates is too different from those that existed during the crisis being modeled. Therefore II is true. III and IV are false as volatility is modeled as a relative shock and spreads are modeled as absolute shocks.