FRM Part I · FRM Exam Part I · Stress Testing
A risk manager notes that the bank's stress tests of its trading book use scenarios built only from the worst historical market moves of the past decade. Which weakness of this approach is most important from a governance perspective?
The main weakness is that purely historical scenarios may omit plausible severe events with no precedent, leaving management falsely reassured. Good governance supplements historical scenarios with hypothetical ones that reflect current vulnerabilities, new products and changed correlations.
- AHistorical scenarios always produce losses that are too large to be useful
- BHistorical scenarios cannot be expressed in terms of risk factors
- CHistorical scenarios may miss plausible severe events that have not yet occurred, so management may be falsely reassuredCorrect
- DHistorical scenarios require a normality assumption that hypothetical scenarios do not
Explanation
Historical scenarios are anchored to past events and can omit plausible shocks with no precedent, such as new risk interactions or structural changes. This creates a false sense of security. They do not necessarily overstate losses, can be mapped to risk factors, and do not require normality.
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