1. msci.com ©2011. All rights reserved. msci.com Reverse Stress Testing Ron Papanek

2. msci.com ©2011. All rights reserved. Agenda  What is Reverse Stress Testing?  Why is it important?  Practitioner Examples  Single-Factor  Multi-Factor  Historical  Monte Carlo  Related Stress Tests  Historical Unwind  Liquidity  Hedging

3. msci.com ©2011. All rights reserved. Reverse Stress Testing – What is it?   Portfolio Specific  Incorporating information specific to the fund company, or portfolio.  Create an Explanatory Narrative  Traditional Stress tests quantify loss from a real or potential event  Reverse Stress tests tell a story from the numbers. Definitions Traditional Stress Test Reverse Stress Test Shock  P&L P&L  Shocks

4. msci.com ©2011. All rights reserved. Reverse Stress Testing – Why is it Important?  Engages Management  The methodology leads to a better understanding of firm risk through the process of identifying thresholds and the exploration of macro scenarios  Connects the portfolio risk to the business risk  Provides a different perspective than traditional stress tests  Provides a more thorough examination of tail risk  Can yield more efficient hedging strategies  Tells a story  Advocated by Regulators  FSA, BIS, FED, CRMPG have all voiced support for reverse stress testing  “The emphasis of a ‘reverse-stress test’ would be on identifying the high impact stress events which would cause the firm to fail and considering the appropriate action, if any, to protect against such failure.” FSA 12/2008 (2.27)  Identify systemic risk and trigger points for contagion

5. msci.com ©2011. All rights reserved. Reverse Stress Testing Sensitivity Analysis  One Factor - Simple, Predictive, Multiple correlated factors  Multifactor – two or more independent risk factors Scenario Analysis  Historical – Date Range  Monte Carlo – Loss simulations Reverse Stress Test Methodologies

6. msci.com ©2011. All rights reserved. Reverse Stress Testing - One Factor Traditional stress test  is a function  not necessarily monotonic. Reverse stress test  is not a function  Different shocks can produce the same P&L

7. msci.com ©2011. All rights reserved. Two Factor Reverse Stress Test One P&L Equity Shift

8. msci.com ©2011. All rights reserved. Sensitivity Analysis  One Factor – One Dimension  Two Factors – Two Dimensions  Locking two factors together allows us to introduce a third factor Multi-Factor

9. msci.com ©2011. All rights reserved. Two Factor Reverse Stress Test

10. msci.com ©2011. All rights reserved. Multi-Factor Sensitivity Grid 20 % 3 0 % 40 % 50 %

11. msci.com ©2011. All rights reserved. Reverse Stress Testing - Historical  Run a traditional Historical stress test and sort by threshold violation.  Run same Historical stress test, but widen period from days to rolling periods, widening periods until loss threshold is triggered.  The output of the Reverse Historical Stress Test is a series of dates and date ranges. Steps

12. msci.com ©2011. All rights reserved. Reverse Stress Testing Historical Daily 2 Day Weekly Monthly Daily 2 Day

13. msci.com ©2011. All rights reserved. Reverse Historical Stress Test Match date scenario with events to explains the portfolio loss Single Date Date Range September 20, 2008March 2003

14. msci.com ©2011. All rights reserved. Reverse Stress Testing – Scenario Generation How do we simulate a 100 year flood?  Run 100 years worth of Monte Carlo simulated returns  Run Monte Carlo simulated returns using correlation periods from different market regimes. Monte Carlo

15. msci.com ©2011. All rights reserved. Reverse Stress Testing - Scenario  Run long term Historical Simulation  Sort sims by loss threshold and use dates to create a period for correlation calculation  Run Monte Carlo simulated returns report using new “extreme correlation period”  Sort sims by loss threshold and aggregate risk factor scenarios Historical / Monte Carlo Hybrid

16. msci.com ©2011. All rights reserved. Reverse Stress Testing - Simulations Historical / Monte Carlo Hybrid Historical Monte Carlo

17. msci.com ©2011. All rights reserved. Worst to Best Monte Carlo Visualization

18. msci.com ©2011. All rights reserved. Reverse Stress Testing - Simulation Monte Carlo by Position

19. msci.com ©2011. All rights reserved. Reverse Stress Testing - Simulation

20. msci.com ©2011. All rights reserved. Monte Carlo Visualization Reverse Stress Testing - Simulation  Visualization allows the inspection of hundreds or thousands of scenarios  Observe the distribution of individual scenarios (not just the average)  Visually identify hedge positions and hedge effectiveness

21. msci.com ©2011. All rights reserved. Agenda  What is Reverse Stress Testing?  Why is it important?  Practitioner Examples  Single-Factor  Multi-Factor  Historical  Monte Carlo  Related Tools  Historical Unwind  Liquidity  Hedging

22. msci.com ©2011. All rights reserved. Benefits  Provides insight into Bubbles Reverse Stress Testing – Related Tools Historical Unwind Historical Stress Test Historical Unwind Replays History Replays History in Reverse  Separates buy and hold from arbitrage strategies  Identifies increasing leverage  Can highlight trend following  Separates idiosyncratic trends within an asset class

23. msci.com ©2011. All rights reserved. Reverse Stress Testing Historical Unwind 1 2 3 4 month month month month

24. msci.com ©2011. All rights reserved. Reverse Stress Testing Historical Unwind

25. msci.com ©2011. All rights reserved. Reverse Stress Testing Liquidity Portfolio specific Risk  Risk - based on position not security  Test liquidation assumptions with acquisition history  Compare Lock-up to liquidity horizon

26. msci.com ©2011. All rights reserved. Agenda  What is Reverse Stress Testing?  Why is it important?  Practitioner Examples  Single-Factor  Multi-Factor  Historical  Monte Carlo  Related Tools  Historical Unwind  Liquidity  Hedging

27. msci.com ©2011. All rights reserved. Reverse Stress Testing - Hedging  Focus on hedging the tail  Identify and aggregate the most commonly occurring risk factor scenarios  Finding the cheapest and most efficient hedge  Strategies  Costless Collar  Correlated Asset Put Spread  Macro Scenario overlay Hedge the Business not the Portfolio

28. msci.com ©2011. All rights reserved. Reverse Stress Testing - Conclusions  Engage management as much as the risk department  The information flow between CEO and risk department is two way  There is a significant amount of firm specific data that should be incorporated into stress testing and risk management.  Connect a story to the risk  The event has more meaning than the date or the scenario # or the P&L  Firm risk is not portfolio risk – Hedge Appropriately  P&L is linear Risk is not  Reverse Stress Testing helps to identify the conditions for failure allowing for early warning as wells as prevention.

29. msci.com ©2011. All rights reserved. msci.com http://www.riskmetrics.com/events/risk2009