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FRM Part II · FRM Exam Part II · The Evolution of Stress Testing Counterparty Exposures

A bank's stress testing of counterparty exposures shows that a severe market scenario would increase exposure to a hedge fund counterparty well beyond its current limit, but the scenario is dismissed as implausible. Which response best reflects sound stress testing practice?

The bank should keep the scenario and subject its plausibility judgment to challenge, using reverse stress testing. Stress tests exist to expose vulnerabilities that normal models miss, so dismissing a scenario because it seems unlikely, or narrowing it to recent history, undermines the purpose of the exercise.

  1. ARemove the scenario because exposures beyond limits make the results unusable for reporting
  2. BRetain the scenario and use reverse stress testing and senior management challenge to assess whether the scenario's plausibility is being underestimatedCorrect
  3. CReplace the scenario with one calibrated only to the worst move in the past year
  4. DApply the scenario only to counterparties rated investment grade

Explanation

Stress tests are meant to reveal vulnerabilities, including ones that appear implausible. Challenge by management and reverse stress tests help judge whether plausibility is underestimated. Calibrating to the last year's worst move or excluding weaker counterparties narrows the test and hides risk.

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