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FRM Part II · FRM Exam Part II · The Evolution of Stress Testing Counterparty Exposures

A bank moves a large share of its derivatives with dealer counterparties into central clearing and bilateral margin agreements. Which implication should its counterparty stress testing now recognize most explicitly?

Stress testing should recognize that margin calls can increase sharply and procyclically in stress, creating liquidity demands even as credit exposure falls. Margining converts counterparty credit exposure into liquidity risk, so the bank must model the extra initial and variation margin and whether it holds enough liquid assets.

  1. AMargin calls can rise sharply and procyclically in stress, creating liquidity demands even as credit exposure fallsCorrect
  2. BInitial margin eliminates the need to consider liquidity effects in stress scenarios
  3. CNetting benefits disappear because cleared trades cannot be offset
  4. DCredit exposure rises because variation margin is exchanged less frequently

Explanation

Margining reduces credit exposure but converts it into liquidity risk: higher volatility raises initial margin and large variation margin flows are demanded quickly. Stress tests should therefore model margin calls and the liquid assets needed. Option B is wrong because liquidity effects become more important, and option C is wrong because cleared trades are netted.

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