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FRM Part II · FRM Exam Part II · Validating Bank Holding Companies' Value-at-Risk Models for Market Risk

A risk manager explains why a bank holding company should supplement VaR with stress testing. Which statement best reflects the rationale?

Stress tests are needed because VaR reflects losses at a chosen confidence level under typical conditions and says little about extreme events beyond it. Scenario analysis exposes tail vulnerabilities VaR may miss, and it complements rather than replaces backtesting.

  1. AStress tests provide a more precise estimate of the 99th percentile loss than VaR
  2. BVaR describes losses under normal market conditions at a confidence level, so stress tests are needed to examine losses from extreme events beyond that rangeCorrect
  3. CStress tests remove the need for backtesting because they use realized data
  4. DStress testing is only needed if VaR produces more exceptions than expected

Explanation

VaR is a quantile at a given confidence level and is not designed to describe tail events beyond it. Stress tests examine extreme but plausible scenarios and highlight vulnerabilities VaR may miss. They complement backtesting rather than replace it.

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