Stresstesting

Stress Testing. In our view, a risk manager should not rely too much on VaR calculations since they may be underestimated quite often

VaR is only valid under normal market conditions and a series of theoretical assumptions. In a nutshell, VaR is only as good as the model it stems from and must always be interpreted within the set of assumptions

GARBAGE IN – GARBAGE OUT

Stress testing is a tuning process by which we can explore how the portfolio would react to small (Sensitivity Analysis) or more drastic (Stress Tests) changing conditions in the markets. Table 1 employs this clustering according to the size of the shock to exhibit various forms of stress tests.

Backtesting is a statistical procedure where

actual profits and losses are systematically compared to corresponding VaR

estimates.

IV. Stress-Testing On VaR Methodologies

In general, the basis of the Stress-Testing exercise is to recalculate the Value at Risk estimate

by using a higher volatility than the observed one for the historical window selected

Empirical evidence1 demonstrates that correlation is not constant over time;

moreover, it fluctuates in periods of crisis.

Stress-testing shows us how vulnerable a portfolio is to extreme events.

Problem: as volatility increseases, historical correlations change too.

Techniques for stress testing

Stress-testing techniques fall into two general categories: sensitivity tests and scenario tests. Sensitivity tests assess the impact of large movements in financial variables on portfolio values without specifying the reasons for such movements. A typical example might be a 100 basis point increase across the yield curve or a 10% decline in stock market indexes. These tests can be run relatively quickly and are commonly used as a first approximation of the portfolio impact of a financial market move. However, the analysis lacks historical and economic content, which can limit its usefulness for longer term risk-management decisions....