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Introduction to Stress Testing

  • Limitations of VaR
    • Tells that n number of times in 100 days, the loss is not going to exceed N$
    • But it cannot predict the loss when it exceeds!
    • Does not focus on large losses (Tails of distribution)
  • Stress Testing:
    • Supplement to VaR
    • "VaR should always be supplemented with stress testing" has been one of the recommendations
    • of the supervisor

Testing how well a portfolio performs under some of the most extreme market moves seen in the last 10 to 20 years.

Advantages & Disadvantages

  • Advantages:
    • Can take a large number of risk factors into consideration
    • Can specifically focus on the tails (extreme losses)
  • Disadvantages:
    • Highly subjective and can become overcautious
    • Requires complete top management support
  • Two independent sections to the risk report:
    • VAR-based
      • Top-down identification of the relevant risk generators for the trading portfolio
    • Stress testing-based risk report proceeds in one of two ways
      • It examines a series of historical stress events and
      • It analyzes a list of predetermined stress scenarios
  • Capital Allocation
  • Exposure
  • Ride out Turmoil
  • The one significant shortcoming of VaR that stress testing does address is sudden changes in historical correlations
  • If two currencies have been pegged to one another, they will exhibit a high historical correlation. A VaR analysis based on that historical correlation will not address the risk that one of the currencies may be devalued relative to the other. If this is a scenario that concerns management, a simple stress test will offer more insights than would, say, a VaR analysis performed with a modified correlation assumption

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