FRM Part I · FRM Exam Part I · Stress Testing
A bank's risk team wants a stress test that captures the possibility that a historically observed shock is not the worst that could occur, and that links the shock to plausible economic narratives rather than just past data. Which scenario design approach best meets this aim?
A hypothetical scenario built from a forward-looking economic narrative with internally consistent risk factor shocks is best. It can go beyond past events and tie shocks to plausible stories, whereas historical replays and higher-confidence VaR remain anchored to observed data.
- AHistorical scenario replaying the largest one-day move in the past ten years
- BHypothetical scenario built from a forward-looking economic narrative with consistent risk factor shocksCorrect
- CA parametric VaR estimate at the 99.9% confidence level
- DA back-test comparing daily P&L with VaR exceptions
Explanation
Hypothetical scenarios are designed from forward-looking narratives and can include events that have not yet occurred, with shocks set consistently across risk factors. Historical scenarios are limited to what already happened. Raising the VaR confidence level still relies on estimated historical distributions, and back-testing only evaluates model performance.
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