FRM Part II · FRM Exam Part II · The Evolution of Stress Testing Counterparty Exposures
A bank stress tests counterparty exposures using a scenario in which interest rates rise 200 bp. A reviewer notes that the bank's initial margin and collateral are assumed to be received on time and fully available. Counterparty defaults are assumed to occur only after the scenario shock has fully played out, and the bank's own margin calls to counterparties are ignored. Which change would best align the stress test with supervisory expectations?
The stress test should model a longer margin period of risk, collateral delays and disputes, and the liquidity strain from the bank's own margin calls. Supervisors expect these stress-dependent frictions, because assuming timely, full collateral and ignoring outgoing margin understates both counterparty losses and liquidity needs.
- AModel the margin period of risk lengthening under stress, collateral disputes and delays, and the liquidity impact of the bank's own margin callsCorrect
- BShorten the horizon so that the shock is smaller
- CAssume all collateral is cash to avoid valuation issues
- DRemove netting benefits only for investment-grade counterparties
Explanation
Supervisors expect stress tests to capture wrong-way risk, collateral haircuts and delays, longer closeout periods under stress and liquidity drains from the bank's own margin outflows. The weakness described is optimistic collateral and timing assumptions. Shortening horizons or restricting netting selectively does not address them.
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