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FRM Part I · FRM Exam Part I · Stress Testing

Which statement best describes the use of reverse stress testing in risk management?

Reverse stress testing starts from a predefined failure or threshold breach, such as insolvency or a capital shortfall, and identifies the scenarios that could cause it. This reveals hidden vulnerabilities, and it complements rather than replaces forward-looking scenario analysis, which still requires judgment.

  1. AIt identifies scenarios that would cause the firm to fail or breach a defined threshold, helping reveal hidden vulnerabilitiesCorrect
  2. BIt reruns past stress tests in reverse chronological order to validate models
  3. CIt applies the mildest possible shocks to verify that losses are zero
  4. DIt replaces all forward-looking scenario analysis because it needs no judgment

Explanation

Reverse stress testing starts from a defined adverse outcome, such as insolvency or a capital breach, and works back to the scenarios that could produce it. This exposes vulnerabilities that conventional scenarios might miss. It complements rather than replaces scenario analysis and still requires judgment.

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