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Stress Testing

5 important questions on Stress Testing

Principles of scenario analysis?

Revalued, preferably under full-reval if non-linear.
Challenge is to generate realistic, extreme but likely scenarios

What about portfolio vs event?

Event-driven is formulated based on plausbile events that generate movements in the risk factors.

Portfolio-driven, risk vulnerabilities in the current portfolio are identified first that translate into adverse movements in risk factors.

What about unidimensional scenarios?

Sensitivity test, traditional approach to scenario analysis focuses on one variable at a time. Specific movements:
- Parallel yield
- Twisting yield
- Exchange rate
- Volatility, etc.
Point: shock risk factors generally one at a time. But very quick and intuitive.
SPAN, standard portfolio analysis is one example Multiple scenarios and pick the worst to set margins. But on portfolio values and two factors, price and volatility. IT gets a risk-array value.

Biggest challenge is number of factors and scenarios, soon enough the become too big and oppose a hurdle for systematic analysis. Moreover, drawbacks are similar probabilities and ignoring of correlations.

What about models and parameters?

Movement in market variables, Securities valuation, Risk-engine
Two ways:
1) Sensitivity analysis, effect of changing the functional form of the model. PRicing models may fail in times of extreme events. Granularity is needed to measure risks carefully.
2) Model parameters, input into the model. Rely on particular input data.

No simple rule to follow for stress testing. BE aware of limitations, assumptions and measurement errors.

What about policy response?

What to to if size of stress loss appears unacceptably large. Moreover, we can
t withstand every single state of the world. Relevant scenarios are extremely important and require careful planning.

Possible actions:
- Insurance
- Modification
- Restrucutre
- Develop plan (in case that)
- Prepare alternative funding plan