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FRM Part I · FRM Exam Part I · Stress Testing

When designing stress scenarios, a bank's risk committee debates how severe and how coherent the scenarios should be. Which design principle is most consistent with good stress testing practice?

Good practice calls for scenarios that are severe but plausible and internally consistent, with risk factor moves that follow a coherent economic narrative. Arbitrary extreme shocks lack credibility, restricting to common events defeats the purpose, and shocking factors independently ignores the correlations that typically intensify in crises.

  1. AScenarios should be severe but plausible, with risk factor moves that are internally consistent with a coherent narrativeCorrect
  2. BScenarios should use the most extreme moves imaginable, regardless of whether they can be linked to an economic story
  3. CScenarios should be limited to events with a probability above 5% so results can be compared with VaR
  4. DScenarios should shock each risk factor independently so that correlations do not distort the result

Explanation

Good scenarios are severe yet plausible and hang together economically, so that factor moves reflect plausible relationships under stress. Arbitrary extremes lose credibility and usefulness for decisions. Stress tests deliberately look beyond the VaR-type tail, and independent shocks ignore the co-movements that matter in crises.

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