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

A risk manager compares two approaches to scenario design for counterparty exposures: (1) a historical scenario replicating the 2008 market moves, and (2) a hypothetical scenario built from a plausible but unprecedented combination of shocks. Which statement best describes the trade-off?

Historical scenarios are easy to defend because they actually happened, yet they may overlook new vulnerabilities. Hypothetical scenarios can target current portfolio weaknesses and novel combinations of shocks, but they depend on subjective judgment about plausibility and severity.

  1. AHistorical scenarios are always more severe because they use observed extremes
  2. BHypothetical scenarios cannot be applied to derivatives because they lack historical data
  3. CHistorical scenarios are easy to justify but may miss future vulnerabilities, while hypothetical scenarios can target current portfolio weaknesses but depend on judgmentCorrect
  4. DHistorical and hypothetical scenarios give identical results when calibrated to the same loss

Explanation

Historical scenarios are credible and intuitive but backward-looking. Hypothetical scenarios can be tailored to the portfolio's present concentrations and emerging risks, but their plausibility and severity rest on expert judgment.

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