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

A bank's counterparty stress test shows a stressed loss of USD 180 million from a single hedge fund counterparty. Stressed losses are limited to 10% of Tier 1 capital of USD 1.5 billion under the board's risk appetite. What action is most consistent with using the result in governance?

The board's tolerance is 10% of USD 1.5 billion, or USD 150 million, so the USD 180 million stressed loss is a breach. It should be escalated, with mitigation such as reducing exposure, requiring more collateral or hedging, rather than being compared to total capital or adjusted away.

  1. ATake no action since the loss is below total Tier 1 capital
  2. BEscalate the breach of the USD 150 million tolerance and require reduced exposure, additional collateral or hedgingCorrect
  3. CIncrease the stress test confidence level until the loss falls under the limit
  4. DRemove the hedge fund from the stress test scope

Explanation

The tolerance is 10% x 1.5 billion = USD 150 million. The stressed loss of USD 180 million exceeds it by USD 30 million, so it must be escalated and mitigated through exposure reduction, collateral or hedges. Comparing to total capital ignores the stated appetite, and the other options manipulate the test.

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