LO 32.3: Describe a stress test that can be performed on a loan portfolio and on a

LO 32.3: Describe a stress test that can be performed on a loan portfolio and on a derivative portfolio.
Stress testing current exposure is the most common stress test. Financial institutions apply current exposure stresses to each counterparty by repricing portfolios under a scenario of risk-factor changes. Counterparties with the largest current exposures and largest stressed current exposures are typically reported to senior management.
For example, an institution that is stress testing current exposure using an equity crash involving a 23% decline in equity markets may create a table of the top counterparties with the largest stressed current exposure and include their credit ratings, mark-to- market values, collateral values, and current exposures. In effect, the table would indicate to management which counterparties are most vulnerable to a large scale equity market decline and how much the counterparties would owe the financial institution. O f course, financial institutions could construct tables for other stresses as well, including credit events and interest-rate shocks. The different stress scenarios would likely include different counterparties.
However, stress tests of current exposure suffer from two main shortcomings: (1) aggregating results is challenging and (2) it does not provide information on wrong-way risk.
Aggregating stress results needs to incorporate additional information for it to be meaningful. Simply taking the sum of all exposures only looks at a loss that would occur if all counterparties were to simultaneously default, which is an unlikely scenario. In addition, the stressed current exposures do not factor in the credit quality of the counterparty. The stress results, therefore, only look at the trade values and not the counterpartys capacity or willingness to repay its obligations. This difference becomes especially relevant when comparing the exposures between high-risk early stage companies and highly rated mature companies. Nevertheless, the task of incorporating counterparty credit quality into each stress scenario is onerous.
The stress results of current exposure also do not provide information on wrong-way risk. Since the stress measures already omit the credit quality of the counterparty, they cannot provide meaningful information on the correlation of exposure with credit quality.
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2018 Kaplan, Inc.
Topic 32 Cross Reference to GARP Assigned Reading – Siddique and Hasan, Chapter 4
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