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FRM Part I · FRM Exam Part I · Stress Testing

A risk manager at a bank wants a stress test that begins with a specific adverse outcome, such as a sharp fall in house prices combined with rising unemployment, and then works out the effect on the bank's loan portfolio. Which description best fits this approach?

This is scenario analysis. The bank defines a specific adverse economic scenario, such as falling house prices with rising unemployment, and then estimates the resulting portfolio losses. Reverse stress testing starts from a failure outcome instead, while VaR and backtesting do not use a defined narrative shock.

  1. AScenario analysis based on a defined set of macroeconomic conditionsCorrect
  2. BReverse stress testing that starts from the loss that would make the bank fail
  3. CHistorical simulation VaR at the 99% confidence level
  4. DBacktesting of the bank's daily trading VaR model

Explanation

The approach starts with a stated adverse scenario and traces its impact on the portfolio, which is scenario analysis. Reverse stress testing works the other way, beginning with a failure outcome and identifying the scenarios that cause it. VaR and backtesting do not specify a narrative event.

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