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

A risk manager reviews a stress test of exposures to a counterparty whose collateral consists largely of bonds issued by the counterparty's own sovereign. Which concern should the stress test most specifically capture?

The test should capture wrong-way risk. Collateral tied to the counterparty's own sovereign tends to lose value precisely when the counterparty is stressed and defaults, so the collateral shortfall grows when exposure is highest. Normal-time haircuts therefore understate the loss and need to be replaced with stressed ones.

  1. AWrong-way risk, because collateral value may fall sharply just as the counterparty defaults and exposure risesCorrect
  2. BBasis risk between the threshold and the minimum transfer amount
  3. CRight-way risk, because the collateral will appreciate when the counterparty is stressed
  4. DFunding valuation risk from the bank's own credit spread widening

Explanation

Collateral issued by, or highly correlated with, the counterparty's own credit loses value in the stress that causes default, so haircuts based on normal conditions understate the shortfall. A stress test should apply scenario-consistent haircuts and correlation. Option C reverses the direction of the dependence.

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