Explanation:
Stress testing risk factors are assumed to have a linear relationship, but the correlations do change during periods of market distress. The best practice for time horizon selection is between three months and two years because estimates need a short time horizon for the best chance of accuracy. Knock-on effects should be considered, and stress testing should be updated on a monthly basis to keep all data as current as possible.
(Book 4, Module 54.1, LO 54.d)
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Question 19
A bank is considering its stress testing requirements and has determined that:
A
the risk factors typically have stable correlations over time.
B
its best option for a time horizon is five to seven years in order to smooth out business cycle impact.
C
the potential consequences of external forces should also be considered.
D
the stress testing should be updated quarterly to provide current data to decision makers.
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