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

A risk manager reviews a counterparty stress test that applies a 30% equity market fall and a 100 bp rise in credit spreads, with no change to the counterparty's default probability or to collateral haircuts. Which criticism is most valid from a regulatory and governance standpoint?

The main flaw is that the scenario ignores wrong-way risk and interactions between market moves, counterparty default and collateral values. In a severe equity fall, default probabilities and haircuts would rise, so holding them fixed understates counterparty losses.

  1. AThe scenario is too severe because regulators only expect expected-case exposure
  2. BThe scenario ignores wrong-way risk and the interaction between market moves, defaults and collateral, so it may understate lossesCorrect
  3. CThe scenario uses market factors, which are not relevant to counterparty exposure
  4. DThe scenario should use only a single risk factor to remain transparent

Explanation

Counterparty stress tests should capture the joint effect of market moves on exposure, counterparty creditworthiness and collateral values, including wrong-way risk. Holding default probability and haircuts fixed in a severe market shock is internally inconsistent and understates losses. Single-factor tests are weaker, not better.

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