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FRM Part II · FRM Exam Part II · Integrated Risk Management

A bank designs a reverse stress test. Which description best matches the approach?

A reverse stress test begins with a defined adverse outcome, such as insolvency or breach of minimum capital, and works backwards to identify the events and combinations of shocks that could produce it. It differs from applying a given scenario and observing results, and it exposes hidden vulnerabilities.

  1. ARe-running last year's stress test with the shocks applied in the opposite direction
  2. BApplying a regulator's prescribed adverse scenario and reporting the capital ratio at the end
  3. CIdentifying scenarios and combinations of events that would cause the bank's business model to fail or breach a defined severe outcome, such as insolvencyCorrect
  4. DBack-testing the VaR model by comparing realized losses to predicted losses

Explanation

Reverse stress testing starts from a defined failure outcome, for example capital falling below the minimum or loss of viability, and works backwards to find the scenarios that could cause it. This differs from forward-looking scenario application and from VaR backtesting. It helps management challenge assumptions about plausibility and vulnerabilities.

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