Explanation:
A is correct. It is not possible to back-test stressed VaR procedures and outputs because these measures focus on extreme outcomes, which are not expected to be observed with any particular frequency.
B is incorrect. In the case of market risk, VaR or ES-based approaches often have a short time horizon (perhaps only one day), whereas stress testing usually looks at a much longer period (scenarios commonly have a 3-month to 2-year time horizon).
C is incorrect. Backward-looking VaR analysis looks at a wide range of scenarios (some good for the organization and some bad) that reflect history. On the other hand, stress testing looks at a relatively small number of scenarios (all bad for the organization).
D is incorrect. Unlike VaR and ES, stress testing does not provide a probability distribution for losses. Many stress tests employ a small number of scenarios representing a selection of economic and financial conditions (for example, CCAR stress tests in the US feature "baseline," "adverse," and "severely adverse" scenarios). However, these do not represent a comprehensive set of possible outcomes, as do the probability distributions employed for VaR and ES.
Learning Objective: Describe the relationship between stress testing and other risk measures, particularly in enterprise-wide stress testing.
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Q-53. The newly hired CRO of a fast-growing multinational bank is reviewing the bank's stress testing process and VaR-based economic capital framework. The CRO wants to ensure that the bank's framework and methodologies reflect best practices put forward by the Basel Committee. In conducting this review, which of the following statements is most appropriate for the CRO to make?
A
Traditional VaR measures can be tested to see how well they would have worked in the past, but stressed VaR cannot be effectively back-tested.
B
Typically, a VaR-based calculation for market risk capital estimates losses over a multi-year period, while an enterprise-wide stress test focuses on losses over a shorter time period.
C
VaR-based economic capital methods and enterprise-wide stress tests typically look at a similar number of loss scenarios.
D
Enterprise-wide stress tests typically require modeling the full probability distribution of losses, while VaR-based economic capital estimates do not.
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