Stress Testing

Introduction to Stress Testing in Risk Measurement

Overview of Stress Testing Concepts

• This presentation introduces stress testing, focusing on its application within various risk categories including market, credit, operational, banking book interest rate risk, and liquidity.

• Market stress scenario risk measurement has traditionally emphasized traded capital market risks while also considering non-traded treasury risks.

Expanding the Scope of Risk Measurement

• Changes in Fair Value Accounting Standards have broadened the scope to include banking treasury centers, pension funds, and insurance companies.

• Credit stressed scenario risk measurement can be applied to both traded credit and non-traded activities like loans and collateral.

Types of Stress Scenario Risk Measurement

Categories of Stress Scenarios

• Operational stress scenario risk includes qualitative aspects such as anti-money laundering measures.

• Liquidity stress scenarios focus on market liquidity (ability to exit positions) and funding liquidity (meeting liability commitments).

Specific Focus Areas

• Treasury stress scenarios generally target lending institutions with a focus on non-traded banking book interest rate risks.

• Insurance-related risks are included in insurance stress scenarios, covering mortality, morbidity, and reinsurance factors.

Limitations of Traditional Risk Measures

Understanding VAR Limitations

• Market participants may overestimate confidence in Value at Risk (VAR), which does not account for extreme market moves beyond two or three standard deviations.

• VAR assumes historical volatility remains constant; however, this is often inaccurate during stressed conditions.

Real World Implications

• Historical data shows that significant drops in markets can exceed normal distribution assumptions—events considered nearly impossible under typical models occurred during major downturns like 1929 and 2008.

The Need for Improved Stress Scenario Design

Disconnect Between Practice and Reality

• Organizations often rely on outdated stress scenarios that do not reflect current volatility conditions.

Regulatory Compliance Post-Crisis

• Following the 2007 financial crisis, there is a push for organizations to invest in robust stress scenario design as part of prudent management practices.

Constructing Effective Stress Scenarios

Statistical Approach to Measuring Portfolio Risks

• A statistical approach involves calculating daily volatility from historical price data using methods like standard deviation or exponentially weighted moving average (EWMA).

Applying Volatility Multipliers

• A multiplier is applied based on an appropriate confidence level (e.g., 99.95%) along with a liquidity factor reflecting how easily positions can be unwound during market stresses.

Evaluating Portfolio Impact Under Stress Scenarios

Assessing Changes in Fair Value

• Portfolio positions are subjected to each constructed stress scenario to evaluate expected changes in fair value.

Methods for Estimating Profit or Loss

• The most precise method involves replicating individual positions; alternatively, portfolio sensitivity metrics like Delta or Vega can be used through Taylor series expansion.