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

A dealer bank's stress scenario for its derivatives book includes a sharp fall in equity prices, but the scenario also specifies that the interest rates and credit spreads of its largest counterparties stay unchanged. A reviewer criticises the scenario. What is the most valid criticism?

The valid criticism is that the scenario is internally inconsistent. In an equity-driven crisis, credit spreads and interest rates would normally move too, with possible wrong-way effects, so holding them fixed is implausible and likely understates counterparty exposure and losses.

  1. AThe scenario is internally inconsistent, because the stressed variables would be expected to move together in an equity-driven crisisCorrect
  2. BThe scenario is too severe because it shocks equity prices at all
  3. CThe scenario should have used only the 95% quantile of historical equity returns
  4. DThe scenario ignores the need to shock the bank's own funding costs only

Explanation

A good scenario is coherent: in a real equity crash, credit spreads typically widen and rates move, and wrong-way effects may arise. Holding those fixed makes the scenario implausible and understates losses. Severity is not the issue, and the quantile and funding-only points do not address coherence.

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