What are the key components of a market risk stress testing framework?

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AcadiFi · Accepted Answer

A robust market risk stress testing framework has six components. First, a scenario library combining historical events, hypothetical narratives, and reverse-engineered scenarios. Second, a risk factor universe — interest rate curves, FX, equity indices and single names, credit spreads, commodities, and volatility surfaces — each with defined shock magnitudes and co-movements. Third, a full-revaluation or sensitivity-based pricing engine that can revalue the trading book under each scenario, ideally at desk and book levels. Fourth, governance: a stress testing committee with representation from risk, finance, business lines, and independent model validation. Fifth, a limits and actions framework — each scenario maps to tolerance levels, and breaches trigger hedging, position reductions, or capital actions. Sixth, reporting pipelines that deliver results to business heads, the CRO, ALCO, and the board with appropriate frequency (typically daily for headline scenarios, monthly for comprehensive runs). ```mermaid flowchart TD A[Scenarios] --> B[Risk factor
shocks] B --> C[Pricing
engine] C --> D[P&L
by book] D --> E[Limit
check] E --> F[Board +
regulator] ``` For an FRM exam perspective, know the Basel Fundamental Review of the Trading Book (FRTB) requires stress testing for both internal models approach (SA-IMA) and standardized approach firms, with particular attention to non-modellable risk factors. Regulators also expect the framework to be independent of VaR — stress tests should reveal risks VaR misses.

What are the key components of a market risk stress testing framework?

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