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

Before the crisis, a dealer's counterparty stress tests for a hedge fund were run on each trade and compared to a static credit limit. After the crisis, the dealer moved to stress the whole netted portfolio with collateral and margin terms, including a margin period of risk that lengthens in stressed markets. What is the main reason for lengthening the margin period of risk in the stress scenario?

The margin period of risk is lengthened because in stressed markets collateral disputes, operational delays and illiquid positions slow the call, delivery and close-out process, allowing more adverse market movement and therefore greater uncovered exposure before the position is replaced or collateral received.

  1. ACollateral valuation and call disputes and illiquid markets delay close-out, so more market movement can occur before the exposure is coveredCorrect
  2. BLonger periods reduce the netting benefit to zero by definition
  3. CRegulators require the counterparty's credit spread to be held constant
  4. DLonger periods reduce the number of trades in the netting set

Explanation

In stress, disputes, operational delays and illiquidity extend the time to call, receive collateral and close out, so exposure can grow further before it is covered. Netting is not eliminated by a longer period, spreads are not held constant, and trade counts are unaffected.

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