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FRM Part II · FRM Exam Part II · Stress Testing Banks

A bank designs a stress scenario by selecting a severe historical crisis and replaying the observed market moves on the current portfolio. A reviewer criticizes the approach. Which is the most significant limitation of relying only on this type of scenario?

The main weakness is that a historical scenario is backward looking. It may miss vulnerabilities in today's portfolio and new risk factors that were absent in the past event, so it should be supplemented with hypothetical scenarios.

  1. AIt cannot be computed without a parametric distribution assumption
  2. BIt may not reflect current portfolio vulnerabilities or new risks that were absent in the past eventCorrect
  3. CIt always produces losses that are too small to be plausible
  4. DIt requires the bank to estimate correlations from a normal distribution

Explanation

Historical scenarios are easy to explain and plausible by construction, but they are backward looking; the current portfolio may hold exposures or risk factors the past event did not stress. They do not need a parametric distribution, and severity is not necessarily low.

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