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FRM Part II · FRM Exam Part II · Risk, Regulation and Organizational Structure

A risk manager is comparing reverse stress testing with conventional scenario-based stress testing for a leveraged credit fund. Which statement correctly describes reverse stress testing?

Reverse stress testing starts from a defined unacceptable outcome, such as fund failure or a covenant breach, and works backward to identify the scenarios that could produce it. Conventional stress testing does the opposite, starting from a shock and measuring the loss.

  1. AIt starts from a predefined market shock and measures the resulting loss
  2. BIt starts from a defined adverse outcome, such as breaching a leverage covenant or fund failure, and identifies the scenarios that could cause itCorrect
  3. CIt reruns the portfolio through historical crises in reverse chronological order
  4. DIt scales VaR by a multiplier to approximate the worst loss

Explanation

Reverse stress testing begins with an unacceptable outcome like insolvency or covenant breach and works backwards to find plausible scenarios producing it. Option A describes conventional stress testing. The others are not reverse stress tests.

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