What is a 'stress scenario' in stress testing for trading desks?

• A. A mild scenario used for initial tests.
• B. A moderate scenario focusing on liquidity.
• C. A severe but plausible event used to evaluate P&L, risk metrics, and capital under adverse conditions; e.g., sudden rate shock, credit widening, liquidity crunch.
• D. A hypothetical scenario with no impact.

Answer: (C)

A stress scenario tests resilience by modeling a severe but plausible market event that moves many risk factors at once and tightens liquidity. It’s used to see how a trading desk would perform under adverse conditions, evaluating potential P&L, risk metrics, and the amount of capital required to weather the shock. Including things like a sudden rate move, wider credit spreads, or a liquidity crunch, it reveals vulnerabilities and informs risk controls and capital planning. This differs from mild or no-impact scenarios (which don’t push outcomes) and from a moderate scenario that focuses only on liquidity, since a true stress scenario probes the desk’s ability to survive and operate under extreme conditions.