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FRM Part I · FRM Exam Part I · Stress Testing

A risk committee uses stress test results to set limits. Which practice best illustrates using stress testing to complement VaR rather than duplicate it?

Designing a hypothetical scenario featuring correlation breakdown and market illiquidity, then setting limits based on stressed losses against tolerance, complements VaR. It captures structural breaks and tail dynamics that VaR, relying on historical distributions and stable correlations, tends to understate.

  1. ARecalibrating VaR to a 99.9% confidence level and treating the result as the stress loss
  2. BUsing the same historical window for stress scenarios as for the VaR estimate
  3. CDesigning a hypothetical scenario with correlation breakdown and liquidity dry-up, then setting position limits where stressed losses exceed toleranceCorrect
  4. DRunning stress tests only on portfolios where VaR limits are already breached

Explanation

Stress tests add value by capturing events outside the historical distribution, such as correlation breakdowns and illiquidity, which VaR with stable assumptions understates. Linking such results to limits integrates them in risk management. A higher-confidence VaR is still a statistical model on the same data.

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