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FRM Part II · FRM Exam Part II · Integrated Risk Management

When designing a reverse stress test, which approach is correct?

A reverse stress test begins with a defined unacceptable outcome, such as breaching minimum capital or business model failure, and then works backward to identify the combinations of events that could cause it. This contrasts with conventional tests, which start from a scenario and estimate its effects.

  1. AStart with a predefined moderate macroeconomic scenario and estimate the resulting capital ratio
  2. BStart with a specified adverse outcome, such as failure of the business model or breach of minimum capital, and identify the scenarios that could cause itCorrect
  3. CReplicate the worst historical loss and scale it by 1.5
  4. DUse only the bank's regulatory VaR model to generate shocks

Explanation

Reverse stress testing starts from an unacceptable outcome, such as insolvency or business model failure, and works backward to find plausible scenarios that produce it. Starting from a scenario and computing results is a conventional forward stress test.

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