FRM Part II · FRM Exam Part II · The Evolution of Stress Testing Counterparty Exposures
A bank's counterparty stress-testing team is deciding how to treat variation margin when projecting exposure under a severe market shock. Which approach best reflects sound practice for a stress test that covers a short, sharp shock?
Stressed exposure should be modelled over the margin period of risk, recognising that collateral arrives with a delay and its value can move. Assuming instant, full collateral understates risk, while ignoring collateral overstates it, so neither is sound practice.
- AAssume collateral is received instantly and in full, so stressed exposure is zero for all margined counterparties
- BIgnore collateral entirely, because stress tests should only measure uncollateralised exposure
- CModel exposure over the margin period of risk, recognising that collateral is received only after a delay and that its value may changeCorrect
- DAssume the margin call is always met at the next day's close with no disputes
Explanation
Under margining, residual exposure arises from the gap between the last margin exchange and close-out, the margin period of risk. Stress tests should recognise that this period lengthens under stress because of disputes and operational delays. Assuming instant, full collateral understates exposure; ignoring collateral overstates it.
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