FRM Part II · FRM Exam Part II · The Evolution of Stress Testing Counterparty Exposures
A bank wants its counterparty stress testing to identify the scenarios that would be most damaging to the firm, without relying on analysts to guess them in advance. Which approach is designed to do this?
Reverse stress testing is the approach. It starts from a predefined severe loss and works backwards to find the combinations of market moves and counterparty defaults that would cause it, exposing hidden vulnerabilities, whereas historical replay and small sensitivities only test scenarios someone chose in advance.
- AReverse stress testing, which starts from a defined severe loss and searches for the scenarios that would produce itCorrect
- BHistorical replay of the single worst day in the data set
- CSensitivity analysis applying a uniform 1 basis point shift to all curves
- DBacktesting of the 99% exposure model against realised exposures
Explanation
Reverse stress testing begins with a severe outcome, such as a loss threshold, and works backwards to find the market moves and defaults that cause it. This reveals vulnerabilities analysts may not have thought of. Historical replay and small sensitivities only test pre-chosen cases, and backtesting checks model calibration, not vulnerabilities.
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