VRM 8 - STRESS TESTING

Question 1

What is the rationale for the use of stress testing as a risk management tool?

Answer 1

To evaluate implications of extreme but plausible scenarios and ensure capital and liquidity adequacy.

Question 2

What are key aspects of stress testing governance?

Answer 2

Choice of scenarios, regulatory specifications, model building, stress-testing coverage, capital and liquidity stress testing, reverse stress testing.

Question 3

What is the relationship between stress testing and other risk measures?

Answer 3

Stress testing provides a detailed picture of risks when used alongside 𝑉𝑎𝑅 and 𝐸𝑆 in an enterprise-wide context.

Question 4

Why are stressed inputs important in stressed 𝑉𝑎𝑅 and stressed 𝐸𝑆?

Answer 4

They help assess risks based on how market variables behaved during significantly stressful periods.

Question 5

What are the advantages of stressed risk metrics?

Answer 5

• Consideration of extreme scenarios
• Enhanced risk assessment capabilities

Question 6

What are the disadvantages of stressed risk metrics?

Answer 6

• Potential overreliance on historical data
• Complexity in scenario development

Question 7

What are key elements of effective governance over stress testing?

Answer 7

Clear policies, procedures, documentation, validation, independent review, and internal audit roles.

Question 8

What responsibilities do the board of directors and senior management have in stress testing activities?

Answer 8

Overseeing stress testing governance, ensuring compliance, and integrating findings into decision-making.

Question 9

What should comprehensive policies and procedures for stress testing include?

Answer 9

Clear definitions of stress testing processes, roles, documentation standards, and validation procedures.

Question 10

What role does internal audit play in stress testing governance?

Answer 10

Ensures compliance with policies and procedures, and evaluates the effectiveness of stress testing activities.

Question 11

What are the Basel stress testing principles for banks?

Answer 11

Guidelines for implementing stress testing to evaluate capital adequacy and risk management.

Question 12

What is the definition of stress testing?

Answer 12

A risk management activity that evaluates the implications of extreme scenarios on financial institutions.

Question 13

What scenarios are typically selected for stress testing?

Answer 13

Historical scenarios, ad hoc scenarios, and key variable changes.

Question 14

What is an example of a historical scenario used in stress testing?

Answer 14

The 2007-2008 US housing-related recession.

Question 15

How can a moderately adverse scenario be amplified for stress testing?

Answer 15

By multiplying the movements in all risk factors by a specific factor (e.g., double or triple the movements).

Question 16

What is a key consideration when using historical scenarios?

Answer 16

Assuming relevant variables will behave as they did in the past may not hold true.

Question 17

What is a short-horizon stress test?

Answer 17

A stress test assessing impacts from short periods of extreme market movements.

Question 18

What are some key variables that can change in stress scenarios?

Answer 18

• Interest rates
• Volatilities
• Equity prices
• Unemployment rate
• GDP

Question 19

What is the purpose of ad hoc stress tests?

Answer 19

To reflect current economic conditions and assess potential future adverse events.

Question 20

What role do senior management and boards play in stress testing?

Answer 20

They should incorporate stress testing findings into decision-making processes.

Question 21

What does regulatory stress testing require from banks?

Answer 21

To conduct specified stress tests including various scenarios and submit capital plans.

Question 22

What is the Comprehensive Capital Analysis and Review (CCAR)?

Answer 22

A stress test for banks with consolidated assets over USD 50 billion, assessing their strength under various scenarios.

Question 23

What scenarios do banks consider under CCAR?

Answer 23

• Baseline
• Adverse
• Severely adverse
• Internal scenario

Question 24

What are core variables in stress testing?

Answer 24

Variables specified in the scenario definition affecting peripheral variables.

Question 25

What is the knock-on effect in stress testing?

Answer 25

The impact of how firms respond to an adverse scenario, potentially exacerbating conditions.

Question 26

What is reverse stress testing?

Answer 26

Identifying combinations of circumstances that could lead to the failure of a financial institution.

Question 27

What is the difference between stress testing and 𝑉𝑎𝑅/𝐸𝑆?

Answer 27

Stress testing is forward-looking and assesses extreme scenarios; 𝑉𝑎𝑅/𝐸𝑆 are backward-looking and based on historical data.

Question 28

What is stressed 𝑉𝑎𝑅?

Answer 28

A measure calculated using data from particularly stressful periods to assess potential future losses.

Question 29

What time horizon does stress testing typically consider?

Answer 29

Longer periods, often assessing impacts over months to years.

Question 30

What is the focus of stressed 𝐸𝑆?

Answer 30

To evaluate risk exposure based on historical stress periods and potential future scenarios.

Question 31

What does stressed VaR represent?

Answer 31

Stressed VaR represents conditional risk measures based on historical data from particularly stressful periods. ## Footnote It is a form of historical stress testing.

Question 32

How does stress testing differ from traditional VaR measures?

Answer 32

Stress testing considers the impact of a whole year of adverse conditions, rather than just the worst days of a specific period. ## Footnote For example, it might analyze a year like 2008 being repeated.

Question 33

What are stressed inputs?

Answer 33

Stressed inputs are data from past periods when a company faced adverse conditions. ## Footnote These inputs are crucial for calculating stressed VaR and stressed ES.

Question 34

List some factors that can adversely affect a company's external environment.

Answer 34

* Major customer defaults * Raw material price increases * Withdrawal of credit lines

Question 35

What is the importance of taking data from past adverse events?

Answer 35

It helps assess whether a company can survive similar conditions in the future.

Question 36

Fill in the blank: A good example of stress factors for a company that exports furniture is if the exchange rate of INR to USD _______.

Answer 36

rises sharply

Question 37

What are the key advantages of using stressed risk metrics?

Answer 37

* More conservative than traditional VaR and ES * Forward-looking perspective * Focus on longer time periods

Question 38

What are the key disadvantages of using stressed risk metrics?

Answer 38

* Poor response to current market conditions * Lack of probability distribution for losses * Difficulty in backtesting

Question 39

What role does governance play in stress testing?

Answer 39

Governance ensures that stress testing assumptions are thoughtfully considered and results are prudently acted upon.

Question 40

What responsibilities does the board of directors have regarding stress testing?

Answer 40

* Overseeing key strategies * Defining stress testing procedures * Ensuring risk appetite and culture

Question 41

What should senior management ensure regarding stress testing activities?

Answer 41

They should ensure activities are conducted by competent employees and reported periodically to the board.

Question 42

What should written policies for stress testing include?

Answer 42

* Purpose of stress testing * Procedures to follow * Roles and responsibilities * Frequency of testing * Scenario building and selection procedures

Question 43

True or False: Documentation of stress testing activities is often viewed as unimportant.

Answer 43

True

Question 44

What is the role of independent review in stress testing governance?

Answer 44

To provide unbiased assurance that stress testing adheres to policies and considers necessary limitations and uncertainties.

Question 45

What are the Basel stress-testing principles focused on?

Answer 45

* Providing forward-looking risk assessments * Overcoming model limitations * Supporting capital planning * Informing risk tolerance

Question 46

Why is the involvement of board and senior management important in stress testing?

Answer 46

Their involvement ensures effective setting of objectives, scenario definitions, and decision-making based on test results.

Question 47

What shortcomings were identified in stress testing before the 2007-2008 crisis?

Answer 47

* Insufficient risk coverage * Too mild scenarios * Underestimation of correlations between risks

Question 48

Fill in the blank: The Basel Committee published stress-testing principles for banks and their supervisors in _______.

Answer 48

2009