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FRM Part II · FRM Exam Part II · Stress Testing Banks

A bank wants its stress scenarios to capture the risk of an unprecedented event that has no close historical analogue, such as a sudden disruption in a new market structure. Which design choice is most appropriate?

Hypothetical scenarios built from expert judgement and plausible transmission channels are most appropriate. They can represent novel events with no historical precedent, whereas historical scenarios, VaR-calibrated shocks and averages are limited to past or typical conditions and may miss emerging risks.

  1. AHypothetical scenarios built from expert judgement and plausible transmission channelsCorrect
  2. BHistorical scenarios only, since they are objective
  3. CScenarios calibrated to the 99% VaR confidence level
  4. DScenarios using the average of past market moves

Explanation

When no historical analogue exists, hypothetical scenarios built on expert judgement and economic reasoning can capture novel events. Historical scenarios are limited to past experience, VaR calibration reflects ordinary conditions, and averages understate tail events.

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