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

A bank's counterparty stress test assumes that, in a severe market scenario, a derivatives counterparty's collateral will be received on the usual daily schedule even though the scenario involves large and rapid price moves. Which weakness in this assumption is most important for the exposure estimate?

The key weakness is ignoring the margin period of risk. In stressed markets disputes, valuation problems and settlement delays lengthen the time between the last collateral received and close-out, so exposure can grow far more than a normal daily margining assumption implies.

  1. AIt ignores the margin period of risk, which lengthens in stressed markets because of disputes, valuation delays and slower settlementCorrect
  2. BIt overstates exposure because collateral always reduces exposure to zero
  3. CIt treats netting as unenforceable, which raises exposure
  4. DIt assumes the counterparty's credit spread is constant, which cancels the collateral effect

Explanation

Under stress, disputes, valuation difficulties and liquidation delays extend the time between the last margin call received and the close-out, so exposure builds up over a longer margin period of risk than normal. Collateral does not reduce exposure to zero, and the assumption does not concern netting enforceability.

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