Credit Risk Management Practice Exam

What type of shocks can be included in stress testing for loan portfolios?

1. Only interest rate fluctuations

2. Equity crash simulations, credit events, and interest-rate shocks

3. Default rates as a static measure

4. Slow economic growth simulations

The correct answer is: Equity crash simulations, credit events, and interest-rate shocks

The inclusion of various types of shocks in stress testing for loan portfolios is crucial for assessing the resilience of financial institutions against adverse conditions. The correct answer encompasses a comprehensive range of potential stresses that can critically affect loan performance. Equity crash simulations can provide insights into how significant market downturns would impact collateral values and, consequently, the ability of borrowers to repay loans. Credit events, such as defaults or downgrades experienced by borrowers, directly assess the credit risk within a loan portfolio, illustrating potential losses that could be incurred. Additionally, interest rate shocks consider how sudden changes in interest rates can affect borrowers' repayment capabilities and the overall profitability of loans. In contrast, the other options highlight limitations in their scope. Focusing solely on interest rate fluctuations does not capture the broader spectrum of risks. Static measures of default rates overlook the dynamic nature of credit risk and fail to account for changing economic conditions. Similarly, slow economic growth simulations, while insightful, do not encompass other critical factors like market shocks or credit events, which can lead to a more comprehensive understanding of potential vulnerabilities within a loan portfolio. Thus, the multi-faceted approach represented in the correct answer allows for a holistic view of risks associated with loan portfolios.