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FRM Part II Updated
How does the Fed's CCAR supervisory stress test actually work?
Fed publishes 3 scenarios in Feb, banks submit FR Y-14 in April, Fed runs own models, publishes trough CET1 and SCB in June. SCB = max(starting - trough, 2.5%) + dividends.
What is the governance structure for stress testing?
Board approves framework; exec risk committee owns execution; CRO runs methodology; finance owns PPNR; treasury owns liquidity; model validation and internal audit challenge.
How does inventory risk affect market-maker quotes?
Inventory risk: MMs with non-zero positions shade quotes to offset, widening effective spreads...
How does adverse selection widen the bid-ask spread?
Adverse selection: MMs can't distinguish informed traders, so they widen spreads to cover expected losses...
How much do transaction costs actually drag on portfolio performance?
Transaction costs compound significantly: 15–150 bps annually depending on asset class and turnover, eroding compounded returns over decades.
How does the bid-ask spread absorb transaction costs?
The bid-ask spread is what market orders pay to trade immediately. Half-spread per cross, full spread round-trip; it compensates makers for processing, inventory, and adverse selection.
How do I identify binding constraints in a stress test?
Enumerate constraints, compute stressed ratios, rank by distance-to-breach. Smallest headroom wins. Recovery actions must target the binding constraint.
How should I define the loss threshold for a reverse stress test?
Thresholds are capital (CET1 to minimum), liquidity (LCR breach), or franchise (rating downgrade, counterparty loss). Typically the minimum across all three.
How do I run an effective Risk and Control Self-Assessment (RCSA) that doesn't become a check-the-box exercise?
Effective RCSAs use facilitated workshops, inherent/residual assessment, control testing, and action plans — not questionnaire check-boxes.
What are the three components of the bid-ask spread?
Three components: order processing (fixed), inventory (position risk), adverse selection (informed trading)...
How is the Amihud illiquidity ratio calculated and used?
Amihud ILLIQ = average |daily return| / daily dollar volume; simple robust liquidity measure...
How is net interest income (NII) sensitivity modeled?
NII sensitivity projects net interest income over a 12-month horizon under rate shocks and compares it to a base case.
How does reverse stress testing differ from traditional stress testing?
Reverse stress testing starts from failure and solves backward for the scenarios causing it, exposing hidden vulnerabilities...
What is reverse stress testing and how do I actually run one?
Reverse stress testing finds scenarios that break the firm, via analytical search, expert workshops, or Monte Carlo clustering. Outputs feed recovery planning.
How do I design hypothetical stress scenarios with a narrative and calibrated shocks?
Narrative, anchor shocks, propagate remaining factors via conditional models, validate plausibility, committee sign-off.
What is Kyle's lambda and how does it measure market impact?
Kyle's lambda = price impact per unit signed order flow; measures market depth and adverse selection...
What is price slippage and how do we model it?
Slippage = spread + impact + timing + opportunity costs; modeled as linear function of order size, vol, liquidity...
Which historical stress scenarios should a trading book use and how are they calibrated?
Use 1987, 1994, 1998, 2008, 2011, 2020, 2022 and calibrate with rolling windows around event peaks. Relative shocks for equity/FX, absolute for rates/spreads.
What are the key components of a market risk stress testing framework?
Six components: scenario library, risk factor universe, pricing engine, governance, limits framework, and reporting. FRTB embeds stress testing in both SA and IMA.
What is the three lines of defense model and how has it evolved?
The Three Lines Model separates risk ownership, oversight, and assurance — updated in 2020 to emphasize collaboration and include the governing body.
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