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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 is deciding how to build stress scenarios for its derivatives exposures. Which feature best distinguishes a reverse stress test from a standard scenario-based stress test?

A reverse stress test begins with a defined unacceptable outcome, such as a loss threatening the bank's viability, and then searches for the market and counterparty scenarios that could generate it. Standard tests run the opposite way, starting from a scenario and calculating the loss.

  1. AIt starts from a predefined historical event and measures the resulting loss
  2. BIt starts from a specified severe outcome, such as a loss that threatens viability, and identifies the scenarios that could produce itCorrect
  3. CIt applies only a single risk factor shock at a time to isolate sensitivities
  4. DIt replaces the need for any forward-looking judgment by using only observed data

Explanation

A reverse stress test works backward from an unacceptable outcome (for example, a loss large enough to threaten solvency or breach a capital limit) to find the combinations of market moves and counterparty failures that would cause it. A standard test starts from a scenario and computes the loss. Option A describes the standard historical approach.

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