FRM Part I · FRM Exam Part I · Stress Testing
A bank designs a stress test by taking the actual market moves observed during a past crisis and applying them to today's portfolio. A reviewer notes a key limitation of this historical scenario approach. Which limitation is most accurate?
The key limitation is that historical scenarios only replicate events that already occurred, so they may overlook risks from new products, markets or concentrations that the current portfolio holds but the past event did not test. They can still be applied to derivatives and do not need assigned probabilities.
- AIt cannot be applied to portfolios that contain derivatives
- BIt requires the bank to assign subjective probabilities to each shock
- CIt may miss risks from new products or exposures that were not present or relevant in the past eventCorrect
- DIt always produces losses smaller than those from hypothetical scenarios
Explanation
Historical scenarios are anchored to events that already happened, so they may not capture vulnerabilities of today's portfolio, such as new instruments or concentrations. They can be applied to derivatives by revaluation. They do not require probabilities, and nothing guarantees smaller losses.
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