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

A bank's counterparty credit risk team currently stress tests by shocking one market risk factor at a time (for example, equity indices down 20%) and recording the change in exposure. A senior risk manager asks for a design that better captures how losses actually emerge across a large derivatives portfolio. Which change best addresses the main weakness of the current approach?

The best change is to use coherent multi-factor scenarios in which related risk factors move together plausibly. Single-factor shocks miss co-movement between market variables and counterparty credit quality, so larger or more frequent versions of them still understate how losses emerge in a real crisis.

  1. AUse scenarios that move many related risk factors together in a coherent, economically plausible wayCorrect
  2. BIncrease the size of each single-factor shock until losses become severe
  3. CReplace stress testing with a higher confidence level in the CVA VaR model
  4. DRun the single-factor shocks more frequently using the same shock sizes

Explanation

Single-factor shocks ignore the way risk factors and counterparty credit quality move together in a real crisis. Coherent multi-factor scenarios reflect those linkages. Larger or more frequent single-factor shocks still ignore co-movement, and a higher VaR confidence level is not a stress test.

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