FRM Part I · FRM Exam Part I · Stress Testing
A bank's stress testing team wants to identify which combination of market moves would cause the firm to breach its minimum capital ratio, rather than assessing losses from a pre-specified shock. Which approach does this describe, and what is its main advantage?
This is reverse stress testing. It starts from a defined adverse outcome, such as breaching the minimum capital ratio, and works backward to identify the combinations of events that could cause it. Its main advantage is revealing hidden vulnerabilities that pre-specified scenarios may overlook.
- AReverse stress testing, which starts from a defined adverse outcome and works back to the scenarios that could cause it, helping reveal hidden vulnerabilitiesCorrect
- BHistorical scenario analysis, which replays a past crisis to estimate the probability of capital breach
- CSensitivity analysis, which shocks one factor and so is best at finding multi-factor interactions
- DBacktesting, which compares predicted capital ratios with realized ratios to find model errors
Explanation
Reverse stress testing starts with a failure outcome, such as a capital breach, and searches for the scenarios producing it. This can uncover vulnerabilities that forward-looking, pre-specified scenarios miss. Historical scenarios and single-factor sensitivities begin with the shock, and backtesting evaluates model forecasts.
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