Explain what must be weighed, and what proves difficult, when scenarios for stress testing are developed and stress testing models are built.
The idea
Scenarios come from history, with past crises replayed on today's portfolio, or are hypothetical, designed by management and risk managers to reflect current worries. The developer must weigh severity against plausibility. A scenario that is too mild teaches nothing, and one that is too extreme is dismissed. A scenario must also be internally coherent, so that a large equity fall comes with the volatility, credit spread and correlation moves that normally accompany it, rather than shocking one factor alone. Building the model is hard because relationships estimated in normal times, especially correlations, break down in stress. Market liquidity dries up, so unwinding and hedging assumptions are optimistic. Feedback effects such as fire sales and funding pressures amplify first-round losses and are difficult to capture. Scenarios also carry no probability, so judgement is needed in weighing them.
A practice question
What must be balanced when choosing the severity of a stress scenario?
- It must be severe enough to be informative, yet plausible enough that management takes the result seriously. - correct
- It must be set so that the loss equals the firm's available capital, which makes the test pass or fail cleanly.Why not: Scenarios are not tuned to equal capital; that is closer to reverse stress testing.
- It must be set at the worst loss in history, since anything milder is not a stress test.Why not: There is no rule that the worst historical loss is the standard; scenarios can be hypothetical and more severe or different.
- It must be set at the 99% quantile so that the probability of the scenario is exactly known.Why not: Scenarios are not quantiles of a distribution and normally do not have a known probability.
A scenario that is too mild teaches little, while one that is too extreme is dismissed. Weighing severity against plausibility is a central judgement in scenario design.
A harder one
A scenario shocks the equity index down 30% but leaves volatility, credit spreads and correlations unchanged. What is the main flaw?
- It is a single-factor shock, and stress testing rules require at least three factors to be shocked.Why not: There is no such rule; the flaw is internal inconsistency with other risk factors.
- It is not coherent: such a fall normally comes with higher volatility, wider spreads and higher correlations, so losses are understated. - correct
- It is a sensitivity analysis, which is the standard approach for scenarios because it isolates the effect of a single risk factor from all the others.Why not: Isolating one factor is sensitivity analysis; a scenario should move related factors together in a consistent way.
- It overstates losses because equity falls usually reverse quickly, so the shock should be halved.Why not: Nothing implies the shock should be halved; the omission of related moves tends to understate losses.
Scenarios must be coherent. A large equity decline is typically accompanied by rising implied volatility, credit spread widening and rising correlations, so ignoring them understates the loss.
The hardest tier
A stress test assumes the bank can sell its positions at current mid prices within 10 days and hedge dynamically as the scenario unfolds. Which criticism is most appropriate?
- The assumption is acceptable because stress tests are defined over a one-day horizon, so liquidity is irrelevant to the scenario loss estimate that is reported to management.Why not: Stress horizons are not fixed at one day, and liquidity is a key issue over the scenario period.
- Liquidity belongs in the VaR model, not in stress testing, so it can be ignored in scenario design.Why not: Liquidity effects are a central consideration in stress scenarios, not something to ignore.
- Hedging assumptions matter only for credit risk, so market risk positions can always be hedged at current prices.Why not: Hedge availability and cost change in stressed markets for market risk positions as well.
- In stress, liquidity dries up and spreads widen, so assumed unwinding and hedging overstate mitigation; use longer liquidity horizons or liquidity costs. - correct
In crises, bid-ask spreads widen and large sales move prices. Assuming smooth exit at current prices makes the loss look smaller than it would be, so management actions and liquidity horizons must be weighed carefully.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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