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FRM Part I · FRM Exam Part I · Stress Testing

A bank compares its 99% one-day VaR of 20 million with a stress loss of 150 million from a severe scenario for the same portfolio. A senior manager argues that because the VaR is well within limits, the stress loss is irrelevant. Which response best reflects sound use of stress testing alongside VaR?

The manager is wrong: stress tests complement VaR. VaR ignores losses beyond its confidence level and depends on recent data, while stress tests probe severe, possibly regime-changing events. Limits, capital planning and contingency actions should consider both measures rather than relying on VaR alone or replacing it.

  1. AAgree, since VaR already captures all losses beyond the 99% confidence level
  2. BDisagree, because stress tests examine severe, possibly regime-shifting events that VaR, based on recent data and a confidence level, does not capture; limits and contingency plans should consider bothCorrect
  3. CAgree, since stress losses of this size are by definition impossible if VaR is within limits
  4. DDisagree, because stress tests should replace VaR as the only limit-setting metric

Explanation

VaR says nothing about losses beyond its quantile and relies on historical data that may not include crises or structural changes. Stress tests capture extreme, plausible events and complement VaR in limits, capital and contingency planning. They are not meant to replace VaR, and a low VaR does not make large stress losses impossible.

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