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

A risk manager wants a counterparty stress test scenario for a bank with large interest rate swap exposures to hedge funds. Which design is most consistent with good practice for selecting scenarios that capture wrong-way risk?

Good scenario design stresses market factors and counterparty default likelihood together for names whose credit depends on those factors, and also stresses collateral values and close-out periods. Holding either exposure or default probability fixed misses wrong-way risk, which is exactly what stress tests should reveal.

  1. AShock market risk factors with their historical correlations held fixed and assume counterparty default probabilities stay unchanged
  2. BShock market factors and simultaneously raise default probabilities of counterparties whose creditworthiness is linked to those factors, while stressing collateral values and close-out periodsCorrect
  3. CShock only counterparty credit spreads, leaving exposure drivers unchanged
  4. DUse the 99% expected exposure profile from the regular CVA model as the stress outcome

Explanation

Wrong-way risk arises when exposure and default probability rise together, so a stress scenario must link market moves to counterparty credit deterioration. Good design also stresses mitigants such as collateral value and margin period of risk. Options A and C break the link between exposure and default, and D is not a stress at all.

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