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

When selecting stress scenarios for counterparty exposures to a concentrated set of clearing members and bilateral counterparties, which principle best supports effective scenario selection?

Scenarios should be built around the portfolio's actual concentrations and main risk drivers, including defaults of the largest counterparties and illiquid collateral. Limiting them to statistically estimable or limit-conforming events would hide the very vulnerabilities stress testing is meant to reveal.

  1. AUse only scenarios whose probability can be estimated statistically from the last year of data
  2. BSelect scenarios targeting portfolio concentrations and key risk drivers, including default of the largest counterparties and liquidity of collateralCorrect
  3. CLimit scenarios to those that keep losses within existing risk limits
  4. DUse the same single scenario for all counterparties to ensure comparability

Explanation

Effective scenarios are designed around the portfolio's specific concentrations and drivers, such as large counterparty defaults, correlated shocks and collateral illiquidity. Restricting to statistically estimable or limit-conforming scenarios defeats the purpose of stress testing.

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