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Answer: Extremely adverse scenarios can be developed from moderately adverse periods in the past by multiplying movements in all risk factors by a certain amount, although this approach may fail to account for changes in correlations between these factors.
B is correct. Sometimes, a moderately adverse scenario from the past is made more extreme by multiplying the movements in all risk factors by a certain amount. However, this approach assumes there is a simple linear relationship between the movements in risk factors. This is not necessarily the case, because correlations between risk factors tend to increase as economic conditions become more stressed. A is incorrect because one approach to scenario building is to assume that a large change takes place in one or more key variables. In general, as stress tests are designed to be forward-looking, it is useful to consider scenarios that have not necessarily occurred in the past. C is incorrect because sometimes, historical scenarios are based on what happened to all market risk factors over one day or one week (e.g., October 19, 1987, or September 11, 2001). These short-horizon stress tests can be supplements to stressed VaR and stressed ES calculations. D is incorrect because senior management should challenge key assumptions in stress testing scenarios or suggest new scenarios for consideration. Involving senior management in building scenarios makes it more likely that the stress testing will be taken seriously and used for decision-making.
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The Chief Risk Officer (CRO) of an international banking corporation has assigned a group of risk analysts the responsibility of developing scenarios for an upcoming stress test. The analysts are currently deliberating on the common methodologies that financial institutions use to construct these scenarios. Among the following statements regarding the stress testing scenarios, which one is correct?
A
Scenarios that have not occurred in the past, but are created by assuming changes of a certain amount in key variables, are typically not used in stress testing.
B
Extremely adverse scenarios can be developed from moderately adverse periods in the past by multiplying movements in all risk factors by a certain amount, although this approach may fail to account for changes in correlations between these factors.
C
Historical scenarios of one day or one week in length are not useful in stress testing because such periods are not considered long enough to pose a meaningful threat to a bank's financial stability.
D
Senior management should leave the development of scenarios to risk managers and analysts who have the deepest knowledge of the risk exposures of the various business lines.