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

A risk manager compares two counterparty stress-testing approaches. Approach A applies a single historical shock (for example, the 2008 move in credit spreads and rates) to all positions. Approach B starts from a loss the bank considers intolerable, such as a given counterparty default loss, and searches for the scenarios that would produce it. Which description is correct?

Approach A is a historical scenario because it replays an observed past shock, while Approach B is reverse stress testing because it begins with an unacceptable loss and identifies the scenarios that could cause it, rather than starting from a prescribed shock.

  1. AA is reverse stress testing and B is sensitivity analysis
  2. BA is a historical scenario and B is reverse stress testingCorrect
  3. CBoth are reverse stress tests because they use extreme shocks
  4. DA is reverse stress testing and B is a historical scenario

Explanation

Applying an observed past shock is a historical scenario. Starting from a defined unacceptable outcome and working back to the causing scenarios is reverse stress testing. Options A and D swap the labels, and C ignores that only B works backward from the loss.

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