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FRM Part II · FRM Exam Part II · Portfolio Risk: Analytical Methods

A risk committee is reviewing why a bank relies on both analytical VaR and stress testing for a portfolio of fixed income and derivative positions. Which statement BEST describes how the two complement each other?

VaR provides a probability-based loss estimate under assumed return distributions, but says nothing about losses beyond its threshold. Stress tests analyze specific severe scenarios outside those assumptions, so using both gives a fuller view of tail and model risk.

  1. AVaR gives a probabilistic loss estimate under assumed distributions, while stress tests examine specific severe scenarios that may lie beyond those assumptionsCorrect
  2. BStress tests give a statistical confidence level, while VaR examines only hypothetical events
  3. CVaR captures all losses beyond its confidence level, so stress tests are redundant
  4. DStress tests are only valid if returns are normally distributed

Explanation

VaR is a statistical estimate dependent on distributional assumptions and a confidence level, and says nothing about losses beyond the threshold. Stress tests use chosen extreme scenarios without assigning a probability, covering events that the distributional model may underweight. The two are used together.

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