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

A dealer bank's counterparty credit risk team historically stressed only the market risk factors that drive trading book P&L, and applied them to counterparty exposures on a standalone basis for each counterparty. After a review, the head of risk argues that this approach is inadequate for a firm with large derivative portfolios. Which is the most appropriate reason?

Counterparty exposure depends on netted portfolio value and on the counterparty's creditworthiness, which can respond to market moves differently from trading P&L. Scenarios must therefore be designed to stress exposure and default likelihood jointly, not simply reuse trading book market shocks.

  1. ACounterparty exposure depends on market risk factors in a different way from trading book P&L, so scenarios must be chosen to stress exposure and default likelihood jointlyCorrect
  2. BCounterparty exposures cannot be affected by market risk factors because they are driven only by credit ratings
  3. CStress tests of counterparties are required only for central counterparties and not for bilateral trades
  4. DStandalone counterparty stress tests are preferred because they avoid the need to model netting

Explanation

Exposure to a counterparty is driven by the netted portfolio's value, and can be large where the trading book's P&L is small or even positive, for example with one-way wrong-way positions. Scenarios therefore need to target exposure and creditworthiness together. The other options misstate how exposure works or what is required.

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