Describe a basic approach to performing a credit stress test on a portfolio.

• A. Increase interest rates by a fixed amount and assume no change in exposure.
• B. Define economic scenarios, adjust PD/LGD, run simulated losses, assess capital impact, and identify mitigating actions.
• C. Ignore external factors and assume baseline PD.
• D. Re-calculate price-to-earnings ratio.

Answer: (B)

A basic credit stress test on a portfolio involves modeling adverse economic scenarios, adjusting risk parameters, simulating losses, assessing capital impact, and identifying mitigating actions. Start by crafting plausible stress scenarios that affect key drivers like unemployment, GDP, and interest rates. Then reflect those conditions by moving risk parameters such as the probability of default and loss given default to higher, more stressed levels. Run simulated losses across the portfolio under those scenarios to quantify potential credit losses. Next, evaluate how much capital would be consumed by those losses and whether current buffers would remain adequate. Finally, outline actions to reduce risk or bolster resilience, such as tightening underwriting standards, adjusting exposures, or increasing collateral or credit enhancements. This approach captures how stress affects both losses and capital, rather than relying on a fixed rate move with no change in exposure, ignoring external factors, or focusing on unrelated metrics like price-to-earnings ratios.