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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 wants its stress tests to capture wrong-way risk on exposures to a commodity producer that has sold forward contracts to the bank. Which design feature is most appropriate?

The stress should shock the commodity price and raise the producer's default probability at the same time, consistently. Wrong-way risk comes from the link between exposure and credit quality, so independent or single-factor stresses would understate the combined loss.

  1. AApply a market shock to the commodity price and simultaneously raise the producer's default probability consistent with that shockCorrect
  2. BStress only the producer's credit spread while holding all market risk factors at current levels
  3. CApply a uniform 10% shock to every risk factor across all counterparties
  4. DStress market factors independently and then add the resulting exposures to an independently derived default loss

Explanation

Wrong-way risk arises from dependence between exposure and counterparty credit quality. A coherent scenario must move the market factor and the counterparty's default probability together. Stressing them independently or only one of them misses the joint effect.

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