Credit Risk Management Practice Exam

Why is using current exposure considered a pitfall in stress testing?

1. It is too broad

2. It may lead to significant errors in measurement

3. It provides too much data

4. It does not account for past performance

The correct answer is: It may lead to significant errors in measurement

Using current exposure in stress testing is seen as a pitfall because it may lead to significant errors in measurement. Current exposure typically captures the existing risk in a portfolio at a specific moment in time without considering potential future changes or variability in risk factors. When stress testing, the intention is to simulate adverse scenarios, which may include new behaviors in counterparty risk, market conditions, or economic environments that have not been observed yet. If the stress test relies solely on current exposure, it could misrepresent the potential risks that could arise from these future developments, resulting in inaccurate risk assessments and misguided decision-making. In contrast to other options, the focus here is not that current exposure is too broad or provides too much data. Additionally, not accounting for past performance does not directly tie into the limitations of current exposure, as the main issue lies in the static nature of capturing risk at a single point rather than considering its dynamic assessment across various time frames or scenarios.