1. Scenario Analysis and Stress Testing
Chapter 17
Risk Management and Financial Institutions 2e, Chapter 17, Copyright © John C. Hull 2009

2. Stress Testing Key Questions How do we generate the scenarios?
How do we evaluate the scenarios?
What do we do with the results?
Risk Management and Financial Institutions 2e, Chapter 17, Copyright © John C. Hull 2009

3. Generating the scenarios
Stress individual variables
Choose particularly days when there were big market movements and stress all variables by the amount they moved on those days
Form a stress testing committee of senior management and ask it to generate the scenarios
Risk Management and Financial Institutions 2e, Chapter 17, Copyright © John C. Hull 2009

4. Core vs Peripheral Variables
If scenario generated involves only a few “core” variables, regress other “peripheral” variables on the core variables to determine their movements. (Kupiec, 1999)
Ideally the relationship between peripheral and core variables should be estimated for stressed market conditions (Kim and Finger, 2000)
Risk Management and Financial Institutions 2e, Chapter 17, Copyright © John C. Hull 2009

5. Making Scenarios Complete
Often an adverse scenario has an immediate effect on the value of a portfolio and a “knock on” effect
Examples
Credit crisis of 2007
LTCM
Risk Management and Financial Institutions 2e, Chapter 17, Copyright © John C. Hull 2009

6. Reverse Stress Testing
Use an algorithm to search for scenarios where large losses occur
Can be a useful input to the stress testing committee.
Risk Management and Financial Institutions 2e, Chapter 17, Copyright © John C. Hull 2009

7. What are the Incentives of a Financial Institution?
If the stress testing committee comes up with extreme scenarios more regulatory capital is likely to be required
The stress testing committee may therefore has an incentive to “water down” the scenarios they consider
Risk Management and Financial Institutions 2e, Chapter 17, Copyright © John C. Hull 2009

8. Scenarios Proposed by Regulators?
Will regulators provide their own scenarios to be used by all banks?
Part of the Basel Committee’s consultative document suggests that it is thinking about this as a possibility
There is a danger that, if the scenarios are announced in advance, financial institutions will hedge only against the scenarios (See Business Snapshot 17.1; traffic light options)
Risk Management and Financial Institutions 2e, Chapter 17, Copyright © John C. Hull 2009

9. What to do with the Results?
Should managers place more reliance on stress testing results or VaR results
One idea is to ask the stress testing committee to assign probabilities to scenarios (e.g. 0.05% or 0.2% or 0.5%)
The stress scenarios can then be integrated with the historical simulation scenarios to produce a composite VaR
Risk Management and Financial Institutions 2e, Chapter 17, Copyright © John C. Hull 2009

10. Example from Chapter 12 Scenario Loss ($000s) Probability
Cumul. Probability s5 s4
h494 s3
h339
h329 s2
h349
h487
h131 s1
h227
h495
h441 ….
Risk Management and Financial Institutions 2e, Chapter 17, Copyright © John C. Hull 2009

11. Subjective vs Objective Probabilities
Objective probabilities are calculated from data
Subjective probabilities is base don a individual’s judgment.
Objective probabilities are inevitably backward looking
The procedure just described is a way of combining subjective and objective probabilities.
Risk Management and Financial Institutions 2e, Chapter 17, Copyright © John C. Hull 2009