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FRM Part I · FRM Exam Part I · Stress Testing

A risk manager notes that the firm's stress scenarios shock each risk factor independently by large amounts, but ignore how the shocks would propagate across asset classes. What is the primary weakness of this design?

The main weakness is that independent shocks ignore interactions and correlations among risk factors, so the scenario may be internally inconsistent or miss how stress spreads across markets. It does not necessarily overstate losses, and scenario analysis does not need a normality assumption.

  1. AIt may fail to capture the correlation and interaction among risk factors, making the scenario internally inconsistentCorrect
  2. BIt will always overstate losses because shocks are too large
  3. CIt cannot be applied to portfolios containing options
  4. DIt requires a distributional assumption of normality to be valid

Explanation

Stress scenarios should be coherent: when one factor moves severely, related factors typically move too, and relationships can break down. Independent shocks ignore this, producing implausible or incomplete scenarios. The result need not overstate losses, and scenario analysis does not require normality or exclude options.

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