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FRM Part II · FRM Exam Part II · Integrated Risk Management

A bank's separate stress tests show losses of USD 40 million for market risk, USD 30 million for credit risk and USD 20 million for operational risk under the same scenario. Management simply adds them for USD 90 million. A risk manager argues that, in a severe scenario, the true loss is likely to exceed this sum. Which is the best justification?

The sum may understate the true loss because risk types interact under stress: market declines raise credit defaults and can trigger operational failures, while correlations rise. These compounding effects and feedback loops are not captured when separately computed losses are simply added together.

  1. ADiversification benefits always disappear in stress, so the sum is exactly right
  2. BRisk types interact in stress (for example, correlations rise and market falls increase credit defaults and operational failures), creating compounding effects not captured by simple additionCorrect
  3. COperational risk cannot be included in stress tests
  4. DAdding losses always overstates the total because of double counting

Explanation

Under stress, dependencies strengthen and risk types compound one another, so simple addition can understate the combined loss. Saying addition is exactly right is unfounded, and double counting is not the issue raised.

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