FRM Part II · FRM Exam Part II · The Evolution of Stress Testing Counterparty Exposures
A bank's stress testing framework for counterparty exposures uses a reverse stress test on a large hedge fund portfolio. What is the starting point of this approach?
A reverse stress test starts by fixing an unacceptable outcome, such as a specific loss or capital breach, and then searches for the market and credit scenarios that would produce it. This exposes vulnerabilities that forward-looking scenarios may miss.
- ADefining a severe adverse outcome, such as a specified loss level, and identifying scenarios that would cause itCorrect
- BChoosing the worst historical month and applying it to the portfolio
- CApplying a 99% VaR multiplier to current exposure
- DRunning the regulatory prescribed scenario and reporting the loss
Explanation
Reverse stress testing begins with a predefined unacceptable outcome, such as a loss threshold or breach of capital, and works backward to find the combinations of events that produce it. This reveals hidden vulnerabilities not found by forward scenarios.
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