Topic 68 Stress Testing and Other Risk Management Tools - Answers
Topic 68 Stress Testing and Other Risk Management Tools - Answers
Topic 68 Stress Testing and Other Risk Management Tools - Answers
Which of the following would least likely be associated with conducting a stress test?
Explanation
Stress tests use observed extreme values from historical data or generated extreme values from Monte Carlo
simulations. It would be counter productive to assume kurtosis and skewness are zero because such assumptions
would limit the ability to account for potential losses.
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Assume that the value at risk (VAR) over a 1-day time horizon for an $80 million equity portfolio at the 95 percent
confidence level is calculated to be $792,000. Which of the following is a drawback to this VAR calculation?
✓ C) The actual loss in a time of extreme market stress could be much greater than $792,000.
✗ D) Increasing the time period used in the calculation will increase the VAR.
Explanation
One of the main drawbacks to VAR is that it fails to incorporate the loss that may occur beyond the 95% confidence
level, such as the loss that may occur with an extreme market event. This drawback of VAR is the reason stress
testing is necessary. Note that increasing the time period resulting in an increase in VAR would not be considered a
drawback; the fact that VAR is expressed in dollars means the interpretation would the same for a fixed-income
portfolio and that VAR is a forward-looking measure, not a backward-looking measure.
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✓ C) scenarios are drawn from factors that would likely impact portfolio value.
✗ D) correlation between underlying exposures is ignored.
Explanation
Stress testing has a strong intuitive appeal by identifying key scenarios without assigning specific probabilistic
statements about anticipated losses. Multidimensional stress testing includes correlation effects. Recent historical
data does not provide a complete enough history to identify extreme movements in key variables. Similarly,
anticipating structural shifts is very challenging.
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Explanation
Equity index falling 1% in one day is not unusual based upon historical data.
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Question #5 of 12 Question ID: 439601
Explanation
Stress testing cannot be used to eliminate all risk from a position. It only highlights the extent of losses in different states and
enables contingency planning, which is one of its benefits.
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Which of the following is NOT a disadvantage of using stress testing? Stress testing:
Explanation
The primary purpose of stress testing is to model the effect of non-normal events that may not be reflected in the
typical VAR calculation. Thus it is unlikely that stress testing would only reflect normal events. Stress testing is
susceptible, however, to the analyst's intentional and unintentional misspecification of the model, the failure to
examine the by-products of major factor movements (how does a change in one factor affect the value of another),
and the failure to include the simultaneous adverse movements of risk factors.
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Question #7 of 12 Question ID: 439600
✗ B) Choosing the time period over which the stress will take place.
✓ C) Computing market value at risk.
Explanation
Computing market value at risk is not explicitly part of a stress test. The other possible answers are part of a stress
test along with choosing the amount of stress for each factor.
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Which of the following statements best describes the uses of stress analysis?
✗ A) Scenario analysis can be used to model one-off hypothetical events but not actual events since
their probability of occurrence is very miniscule and, as they have already occurred, they are not
likely to recur.
✗ B) Scenario analysis, which is a special case of stress analysis, suffers from limitations on
implementing a consistent and manageable approach.
✗ C) Stress analysis has several advantages over a value at risk (VAR) only approach that includes:
highlighting inappropriate assumptions, hidden vulnerabilities, and the ability to be able to forecast
probability of rare but damaging events.
✓ D) Stress analysis can be used to enhance VAR analysis by focusing on the extent of loss in an
extreme event.
Explanation
This is the only valid use of stress analysis among the statements listed. Other statements either do not pertain to uses, even
if true in some other context, or are not true.
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Question #9 of 12 Question ID: 439593
Which of the following most accurately describes the relationship between computing internal capital requirements using a
stress testing approach versus a value at risk (VAR) capital strength approach? Stress testing approaches:
✓ A) complement VAR approaches since they account for scenarios that may not be properly
considered in VAR approaches.
✗ B) should never be used since they are based entirely on subjective inputs.
✗ C) are substitutes for VAR approaches since they better measure the entire spectrum of potential
outcomes.
✗ D) can never be combined with VAR approaches because they are based on different probability
distributions.
Explanation
Since VAR often relies on common probability distributions, it may not properly capture extreme, but possible, events. Stress
testing involves evaluating the effects that these events would have on the institution and then establishing capital
requirement based on the findings. The two approaches are natural complements.
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Explanation
Stress testing necessitates scenarios that have not appeared previously or do so very infrequently.
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Question #11 of 12 Question ID: 439599
✓ B) losses are computed based on anticipated movements in key variables without specific
probabilistic statements.
Explanation
Stress testing does not assign a probability to an expected loss but rather evaluates losses based on alternative
scenarios relevant to the firm's operations.
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✓ D) shocks that are less likely to appear than historical evidence indicates.
Explanation
Stress testing analyzes events that are more likely to appear than suggested by historical data.
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