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

After a crisis in which a major dealer failed, a bank revises its counterparty stress testing. Which change best reflects the lesson that counterparty stress tests should capture the interaction of exposure, collateral and default of a large counterparty?

The better design stresses the default of a large counterparty jointly with market moves, collateral haircuts and delayed margin calls over the close-out period. These factors interact in a crisis, so ignoring any one of them understates the losses.

  1. AStressing only the mark-to-market of the portfolio while assuming collateral is always received on time at its full value
  2. BReplacing all stress tests with a single 99% VaR on the current exposure
  3. CStressing the default of a large counterparty together with market moves, collateral haircuts, and margin call delays during the close-out periodCorrect
  4. DApplying the same loss given default to every counterparty regardless of its collateral agreement

Explanation

Large losses arise when the defaulting counterparty's exposure rises, collateral is worth less or arrives late, and close-out takes longer because of market stress. A test combining these effects captures the interaction. The other options ignore collateral frictions or remove sensitivity to the specific agreement.

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