6 stress testing involves estimating how the

Info icon This preview shows pages 13–15. Sign up to view the full content.

View Full Document Right Arrow Icon
6. Stress testing : involves estimating how the portfolio would have performed under extreme market moves. Two Main approaches : a. Scenario analyses, in which we evaluate the impact of specified scenarios (e.g., such as a particular fall in the stock market) on our portfolio. The emphasis is on specifying the scenario and working out its ramifications. b. Mechanical stress tests, in which we evaluate a number (often a large number) of mathematically or statistically defined possibilities (e.g., such as increases or decreases of market risk factors by a certain number of standard deviations) to determine the most damaging combination of events and the loss it would produce. 7. stress testing – scenario analyses: - Stylized scenarios: Some stress tests focus on particular market variables. a. Shifting a yield curve by 100 basis points b. Changing implied volatilities for an asset by 20% of current values. c. Changing an equity index by 10%. d. Changing an exchange rate for a major currency by 6% or changing the exchange rate for a minor currency by 20%. - Actual historical events: stress tests more often involve making changes to several market variables – use historical scenarios. E.g. set the percentage changes in all market variables equal to those on October 19, 1987. - If movements in only a few variables are specified in a stress test, one approach is to set changes in all other variables to zero. Another approach is to regress the nonstressed variables on the variables that are being stressed to obtain forecasts for them, conditional on the changes being made to the stressed variables (conditional stress testing) 8. Stress testing – mechanical stress testing - Factor push analysis: we push the price of each individual security or (preferably) the relevant underlying risk factor in the most disadvantageous direction and work out the combined effect of all such changes on the value of the portfolio. a. We start by specify a level of confidence, which gives us a confidence level parameter alpha. b. We then consider each risk factor on its own, ‘push’ it by alpha times its standard deviation, and revalue the portfolio at the new risk factor value; c. We do the same for all risk factors, and select that set of risk factor - 13 -
Image of page 13

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Study Notes: Risk Management and Financial Institutions By Zhipeng Yan movements that has the worst effect on the portfolio value. d. Collecting these worst price movements for each instrument in out portfolio gives us our worst-case scenario, and the maximum loss (ML) is equal to the current value of our portfolio minus the portfolio value under this worst-case scenario. e. Factor push test is only appropriate for certain relatively simple types of portfolio in which the position value is a monotonic function of a risk factor.
Image of page 14
Image of page 15
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern