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

A bank's stress testing team moves from a purely historical scenario (a repeat of a past crisis) to a hypothetical scenario designed around the largest concentrations in its counterparty book. Which is the main advantage of this change?

A hypothetical scenario can be built around the bank's present counterparty concentrations and can include plausible events that never occurred historically. A purely historical scenario only replays the past and may miss current vulnerabilities. Hypothetical scenarios also need more judgment, not less.

  1. AIt guarantees that the scenario will have a known probability that can be compared with VaR
  2. BIt targets the bank's current vulnerabilities, including events not seen in the historical recordCorrect
  3. CIt removes the need for senior management judgment in scenario selection
  4. DIt makes the results identical to those from the CVA calculation under normal conditions

Explanation

Historical scenarios only reflect events that already happened and may not hit today's portfolio concentrations. Hypothetical scenarios can be built around current exposures and plausible but unobserved events. They require more, not less, judgment, and do not give known probabilities.

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