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FRM Part II · FRM Exam Part II · Risk, Regulation and Organizational Structure

In capital planning for a fund or financial institution, which role does reverse stress testing play?

Reverse stress testing begins with a defined failure outcome, such as breaching a minimum capital level, and works backwards to find the scenarios that could cause it. This exposes hidden vulnerabilities that ordinary forward-looking scenarios may overlook.

  1. AIt identifies the scenarios that would cause the firm to breach a defined failure or capital thresholdCorrect
  2. BIt reverses the signs of historical losses to estimate potential gains
  3. CIt replaces VaR limits with fixed notional limits
  4. DIt estimates expected loss using average default frequencies

Explanation

Reverse stress testing starts from an unacceptable outcome, such as insolvency or breach of a capital minimum, and works backwards to find which combinations of events could produce it. This reveals vulnerabilities that forward scenarios chosen by management may miss.

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