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

A bank's reverse stress test for its derivatives counterparty portfolio identifies a combination of a sharp equity fall, widening credit spreads and the default of its largest dealer counterparty as the scenario that would exhaust its capital. What is the main purpose of the reverse stress test in the governance process?

A reverse stress test starts from an unacceptable outcome, such as capital depletion, and finds the scenarios that would cause it. Management then judges how plausible they are and decides on mitigating actions, limits or hedges. It complements, rather than replaces, forward-looking scenario analysis.

  1. ATo compute the bank's regulatory CVA capital charge
  2. BTo identify scenarios that would cause failure so that management can assess their plausibility and decide on mitigating actionsCorrect
  3. CTo replace the use of historical scenarios in the stress testing program
  4. DTo calibrate the confidence level of the bank's VaR model

Explanation

Reverse stress testing starts from a defined adverse outcome, such as capital exhaustion, and works backward to find the scenarios causing it. Governance then judges plausibility and decides on actions or limit changes. It complements rather than replaces forward scenarios and is not a capital or VaR calibration tool.

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