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

A bank runs a reverse stress test on its counterparty credit risk. The risk committee sets the goal of finding scenarios that would cause a loss of USD 500 million, equal to 25% of its CET1 capital. What is the CET1 capital implied, and what does the reverse approach do differently from a conventional stress test?

CET1 capital is USD 2,000 million, because 500 divided by 0.25 equals 2,000. A reverse stress test starts from a defined damaging outcome, here a USD 500 million loss, and searches for the scenarios that could produce it, unlike a conventional test that applies a given shock.

  1. AUSD 125 million; it applies a given shock and then measures the resulting loss
  2. BUSD 2,000 million; it starts from the loss outcome and identifies the scenarios that could produce itCorrect
  3. CUSD 2,000 million; it starts from a given shock and measures the loss
  4. DUSD 125 million; it starts from the loss outcome and identifies the scenarios that could produce it

Explanation

If 500 is 25% of CET1, CET1 = 500 / 0.25 = 2,000 million (check: 0.25 x 2,000 = 500). A reverse stress test begins with a defined adverse outcome and works back to the scenarios that cause it. The USD 125 million figure comes from multiplying by 0.25 instead of dividing.

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