Credit Risk Management Practice Exam

The choice of linearization of delta sensitivities in models is indeed a common pitfall in stress testing counterparty credit risk (CCR). In the context of CCR, delta sensitivities refer to the change in the value of a derivative with respect to changes in the price of the underlying asset. When linearizing these sensitivities, there is a risk that the model may oversimplify the relationships and fail to capture the non-linearities inherent in many financial instruments, particularly during times of market stress. This simplification can lead to inaccuracies in estimating the potential changes in exposure, especially when prices move significantly away from their current levels, which is common in stressed conditions. Non-linear models, while more complex, typically provide a more accurate representation of how exposures change with varying market conditions. Thus, relying solely on linear representations when conducting stress tests can result in an underestimation or overestimation of risk, ultimately misleading risk management decisions. Other choices are relevant in the broader context of risk management practices but do not embody the specific pitfalls associated with stress testing in the same manner. Using expected exposure uniformly, accurately measuring derivatives market values, or exclusively applying historical data can introduce their own challenges but may not directly relate to the mismanagement of delta sensitivities during stress