FRM Part I · FRM Exam Part I · Stress Testing
A bank's risk team wants to evaluate portfolio losses if the equity market falls 30% and credit spreads widen sharply, using a hypothetical combination of shocks chosen by senior management rather than a repeat of any past episode. Which stress testing approach is this?
This is hypothetical scenario analysis. The shocks, such as a 30% equity fall and wider credit spreads, are designed by management as plausible events rather than replayed from history, and they are not derived backward from a predefined failure outcome as in reverse stress testing.
- AHistorical scenario analysis
- BHypothetical scenario analysisCorrect
- CParametric VaR back-testing
- DReverse stress testing
Explanation
Hypothetical scenarios are constructed by management or risk teams from plausible but not necessarily observed shocks. Historical scenarios replay past events. VaR back-testing compares VaR forecasts with outcomes, and reverse stress testing starts from a predefined failure outcome and works backward to the scenarios causing it.
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