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

A dealer's stress test of a portfolio of uncollateralised interest rate swaps with a hedge fund applies a 200 bp parallel rate shock and leaves the counterparty's default probability unchanged. A reviewer says this design understates losses in a realistic crisis. What is the most appropriate criticism?

The key flaw is that exposure is stressed while default probability is held constant, so the dependence between market moves and counterparty credit quality, wrong-way risk, is ignored. Stress losses depend on both exposure and default likelihood, so a coherent scenario must move them together.

  1. AThe test ignores the link between the market shock and the counterparty's creditworthiness, so wrong-way risk is not capturedCorrect
  2. BThe test should use a 1 bp shock so that it remains linear
  3. CThe test should exclude exposures because only default probabilities matter for counterparty loss
  4. DThe test should be run only at the netting-set level of the dealer's largest counterparty

Explanation

Counterparty loss depends on both exposure and default probability. A realistic stress should let credit quality deteriorate when the market shock raises exposure, which is wrong-way risk. Holding default probability fixed misses this interaction. A smaller shock would not be a stress, and ignoring exposure is incorrect.

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