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

A bank wants its counterparty stress tests to produce scenarios that are plausible and linked to counterparty defaults rather than arbitrary shocks. Which approach is most consistent with the evolution toward integrated stress testing?

The most consistent approach is to build a coherent macro scenario narrative and derive consistent shocks to both market risk factors and counterparty credit quality. This preserves joint behaviour and plausibility, unlike uniform shocks, independent worst moves, or shocks reverse-fitted to limits.

  1. AChoose scenarios from the narrative of a macro event, then derive consistent shocks to market risk factors and to counterparty credit qualityCorrect
  2. BApply the same fixed percentage shock to every risk factor regardless of the narrative
  3. CUse only the worst historical one-day move of each risk factor independently
  4. DSet shocks so that the stressed loss equals the existing credit limit

Explanation

Integrated stress testing starts from a coherent economic narrative and translates it into consistent shocks across market factors and credit quality. Independent worst moves or uniform shocks ignore correlations, and backing into a limit is circular.

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