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FRM Part II · FRM Exam Part II · Liquidity Stress Testing

A bank's treasury team is designing a liquidity stress test. Which scenario design is most consistent with sound practice for capturing both firm-specific and market-wide vulnerabilities?

The best design combines idiosyncratic, market-wide and combined scenarios across multiple horizons, from overnight to several months. This captures different sources and speeds of liquidity strain, whereas a single scenario or an average-based calibration would miss tail events and interactions between firm and market stresses.

  1. ARun a single idiosyncratic scenario, because market-wide shocks are covered by regulatory capital requirements
  2. BRun idiosyncratic, market-wide and combined scenarios, each over multiple horizons such as overnight, one week, one month and three monthsCorrect
  3. CRun only a market-wide scenario, since idiosyncratic events are too rare to model
  4. DRun one scenario calibrated to the bank's average historical outflows over the past year

Explanation

Sound practice uses several scenario types (idiosyncratic, market-wide, combined) and several horizons, because liquidity risk crystallizes at different speeds and through different channels. Using a single scenario or average outflows ignores tail events and interaction effects.

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