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FRM Part II · FRM Exam Part II · Stress Testing Banks

A bank's risk committee is choosing between a historical scenario (replaying the 2008 credit crisis) and a hypothetical scenario (a sudden sovereign downgrade combined with a regional property collapse). Which statement best describes an advantage of the hypothetical scenario?

The hypothetical scenario's advantage is that it can capture novel shocks and combinations not seen historically and can be targeted at the bank's present vulnerabilities. Historical scenarios are anchored in observed data but are backward-looking. Hypothetical designs still need judgment and are not automatically more severe.

  1. AIt can capture risks and combinations of shocks that have not occurred before and tailor them to current portfolio vulnerabilitiesCorrect
  2. BIt is easier to defend because the shock sizes are observed market data
  3. CIt removes the need for judgment about how risk factors move together
  4. DIt guarantees that the scenario is more severe than any historical event

Explanation

Hypothetical scenarios are built from forward-looking judgment, so they can reflect emerging vulnerabilities and novel combinations of shocks. Historical scenarios rely on observed data and are easier to defend, but they are limited to past events. Hypothetical scenarios still require judgment on co-movements and do not guarantee greater severity.

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