Reading 37: Risk Management －LOS m testing, capital, setting

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CFA Institute Area 3-5, 7, 12, 14-18: Portfolio Management
Session 12: Risk Management
Reading 37: Risk Management
LOS m: Demonstrate the use of VAR and stress testing in setting capital requirements.

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Which of the following most accurately describes the relationship between computing internal capital requirements using a stress testing approach versus a value at risk (VAR) capital strength approach? Stress testing approaches:

A) are substitutes for VAR approaches since they better measure the entire spectrum of potential outcomes.

B) should never be used since they are based entirely on subjective inputs.

C) complement VAR approaches since they account for scenarios that may not be properly considered in VAR approaches.

D) can never be combined with VAR approaches because they are based on different probability distributions.

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Answer and Explanation

Since VAR often relies on common probability distributions, it may not properly capture extreme, but possible, events. Stress testing involves evaluating the effects that these events would have on the institution and then establishing capital requirement based on the findings. The two approaches are natural complements.

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Stress testing approaches are not constrained by many of the constraints associated with the traditional distribution based value at risk (VAR) approaches. Which of the following is an example of a constraint associated with the traditional VAR approach but NOT the stress testing approach? The traditional VAR approach:

A) ignores extreme events.

B) places too high a probability on extreme events.

C) places too small a probability on extreme events.

D) places too small a probability on expected events.

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Answer and Explanation

Common probability distributions (i.e., normal distributions) tend to place extreme low probabilities on extreme events.

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Which of the following describes the best way to resolve the differences between the stress testing approach to computing capital requirements and the value at risk (VAR) approach?

A) Ignore the VAR approach since it ignores extreme events.

B) Use both approaches and then use the larger of the two capital requirements.

C) Ignore the stress testing approach since it is too subjective in nature.

D) Integrate the two approaches by using an optimization algorithm.

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Answer and Explanation

Where the stress testing approach is weak, the VAR approach is strong and vice versa. A possible way to combine the two approaches would be to compute the capital requirements using each method and then use the larger of the two values. This ensures that the capital requirement meets the needs of both approaches.