FRM Part II · FRM Exam Part II · Global Financial Stability Report, April 2025, Chapter 2 (Geopolitical Risk)
A bank's risk committee wants to incorporate geopolitical risk into its stress testing programme after reviewing the IMF's April 2025 Global Financial Stability Report analysis. Which approach is most consistent with the policy-oriented message of that analysis?
The best approach is to build forward-looking scenarios that connect geopolitical shocks to asset prices, funding conditions and portfolio losses, and include them in stress testing. Geopolitical risk transmits through several channels and is poorly captured by historical averages, so scenario analysis is the appropriate tool.
- ARely solely on historical average market volatility, since geopolitical events are too rare to model
- BDesign forward-looking scenarios that link geopolitical shocks to asset prices, funding conditions and portfolio losses, and include them in stress testsCorrect
- CLimit geopolitical analysis to sovereign exposures in the home country
- DTreat geopolitical risk as purely operational and exclude it from market and credit stress tests
Explanation
The IMF analysis stresses that geopolitical risk can transmit to asset prices, capital flows and financial stability, so supervisors and firms should use forward-looking scenario analysis. Using only historical volatility underestimates tail risk. Confining it to home sovereign exposure or to operational risk ignores cross-asset and funding channels.
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