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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 historically stressed only the market risk factors driving trade values, such as rates and FX, and measured the resulting exposure on each counterparty. After the global financial crisis, supervisors asked for stress tests that also reflect a deterioration in the counterparty's own credit quality at the same time. Which feature does this change most directly address?

The change addresses wrong-way risk. Stressing only market factors misses cases where exposure increases just as the counterparty's credit quality deteriorates, so combining market and credit stresses captures the dangerous correlation between exposure and default likelihood that crisis experience revealed.

  1. AWrong-way risk, where exposure rises as the counterparty's creditworthiness fallsCorrect
  2. BBasis risk between cash and futures prices
  3. CSettlement risk arising from time-zone differences
  4. DPrepayment risk on securitised collateral

Explanation

Stressing market factors alone ignores the link between exposure and counterparty default likelihood. Joint stress of exposure and credit quality captures wrong-way risk. The other options are unrelated to this combined stress.

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