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FRM Part II · FRM Exam Part II · Risk, Regulation and Organizational Structure

A hedge fund manager designs a stress-testing program for a multi-strategy fund. Which design choice best reflects sound practice for identifying vulnerabilities that historical VaR may miss?

The best practice is to combine historical scenarios with hypothetical forward-looking ones, including liquidity and correlation shocks. Stress testing exists to reveal tail vulnerabilities that VaR and past data miss, so limiting it to past events or to VaR-sized losses would defeat its purpose.

  1. AUse only scenarios replicating past crises, since they actually occurred
  2. BCombine historical scenarios with hypothetical forward-looking scenarios, including shocks to liquidity and correlationsCorrect
  3. CSet stress scenarios so that the portfolio loss never exceeds the fund's VaR
  4. DRun stress tests only on the largest ten positions to limit workload

Explanation

Stress tests complement VaR by covering tail events and breakdowns in historical relationships. Using both historical and hypothetical scenarios, including liquidity and correlation shocks, captures vulnerabilities that past data may not contain. Relying only on past crises ignores new risks, and restricting scenarios to VaR defeats the purpose.

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